How to spot a company in financial distress – part 2

The coronavirus shutdown in wreaking havoc on the economy, grinding business to a halt and forcing many companies to make the tough decision to let staff go.

Non-essential businesses like gyms, pubs and cinemas are under total shutdown to slow the spread of the virus, while those whose staff are working from home, are turning to online sales and delivery for survival.

As investors, we understand that all businesses have their ups and downs. That's why we diversify – to spread our risk so we're not reliant upon a single investment for all our returns. But no one wants to risk investing in a company that's vulnerable to default and bankruptcy.

The coronavirus outbreak has come at a time when years of low interest rates and easy credit have  allowed companies to borrow big, building a record mountain of debt.

So, how can you recognise the early warning signs of a business in financial distress?

Yesterday, we brought you part 1 in this series, which walked through how you can be on high alert for balance sheet weakness and when short-term debt can become a problem.

Today, we'll move to long-term debt and how to recognise the presence of default triggers in finance arrangements.

MORE IN THIS SERIES:

How to spot a company in financial distress – part 1

How to spot a company in financial distress – part 3

When is the debt due? – long-term debt

As discussed in part 1, there are two main categories of liabilities: current liabilities (due within one year) and noncurrent liabilities (longer-term). While s companies with long-term debt on the balance sheet and in pretty good shape, investors shouldn't ignore it. That's because companies may have to dip into their cash reserves or earnings to pay down long-term debt. This can jeopardise a company’s ability to meet interest payments and fund future projects.

To uncover whether a company is at risk, consider how much room it has to service its debt. For this, there are two types of measures:

• Interest Coverage Ratio - used to determine how easily a company can pay interest on its outstanding debt
• Cash Flow Coverage Ratio – this is a liquidity ratio, which measures a company's ability to pay off its debt obligations with its operating cash flows

If a company borrows money in the form of debt, it most likely incurs interest charges. The interest coverage ratio measures a company's ability to meet its interest obligations with income earned. Higher interest coverage ratios are typically better. Interest coverage close to or less than one means the company has some serious difficulty paying its interest.

For the Interest Coverage Ratio, look at the interest expense line item and the net income line item on the income statement. Divide the net income line item by the interest expense line item. You want the ratio to be as high as possible.

Interest coverage ratio=EBIT/(interest expense)

Let's take Automatic Data Processing Inc (ADP) example. They have $2,29 billion as net income and $130 million as interest expense. That gives them a coverage ratio of 17.63. This means income would have to plummet for them not to be able to pay their interest expense. Lower ratios mean that even temporary falls in earnings or cash flow could prevent them from servicing their debt.

The cash flow coverage ratio measures a company's ability to meet its debt obligations with operating cash flows. It helps us understand whether a business could meet its obligations in a temporary slow-down and earnings hit. To measure this, we take the EBITDA (earnings before interest and taxes + depreciation + amortization), and divide it by the total debt. In this case we are using EBITDA as an approximation for cash flow but we could also use several other cash flow measures.

When it comes to cash flow, Morningstar equity analyst Gareth James also points investors to a measure called “cash conversion” – or the proportion of profit that is converted to cash flow. This is because a company may be generating a profit but not necessarily have cash coming in the door.

An example of this is listed consumer law firm Slater and Gordon (SGH) in 2016. The company offered legal services on a “no win, no fee” basis. This means they paid their lawyers to provide a service, but no money was coming in the door until they won the case. However, on the balance sheet they were recognising some of the money up front in anticipation of a win. The trouble was that work was not being converted into cash quickly enough to cover the debt. After teetering on the brink of insolvency for two years, the company recapitalised, and the shareholders were nearly wiped out.

"Cash flow and profit can be very different," James says. "This is why at Morningstar our models are discounted cash flow models, so we focus on cash—not profit."

Keep an eye on debt covenants

In situations involving large debt loads, it’s important to be aware of any financial covenants with bankers or bondholders that can trigger defaults even before the firm runs out of resources.

You can think of a debt covenant like a financial contract – between a borrower and a lender – that states restrictions a company must not breach. If breached, the covenant can allow the lender to, for example, demand full payback of the loan. Think of it as a parent lending money to a child on the condition the child spends the money on textbooks not toys. If the child buys toys, the parent can demand the money back in full immediately.

Times of economic stress can cause these covenants to be broken which means that the borrower (bond holder or bank) can call in the loans or credit lines which can potentially push a company further into trouble or potentially insolvency at a time of distress.

Covenants are often attached to maintaining certain financial ratios – e.g. a debt/EBITDA, maximum debt-to-asset ratio or linked to the share price.

Covenants won't however always been known the public, James says.

"You could have a situation where a company is in perfectly good shape, but the share price is collapsing," James says. "And you may not know that the lender has a covenant where if company falls in value, they can call in the debt or step in and take control.

"Covenants will vary from company to company, but the more you know about them, the better."

In instances where a debt covenant is triggered, a company can seek a waiver or attempt to refinance its debt. Auckland Airport, for example,  has secured debt covenant waivers and issued equity to preserve liquidity during the corona turmoil.

Asset valuation in a crisis

James says to understand a company's liabilities; investors must also understand the types of assets it holds and how they are valued.

"For example, if you're a real estate investment trust and own a billion dollars of property with $500 million worth of debt lenders will be comfortable with that, especially if you can make your interest payments comfortably.

"But if those assets fall 70 per cent in value, then the lenders are going to going to start to worry that there isn't enough left in the tank to fund the loan. They're going to scramble to get hold of the company and liquidate the assets before they lose any more money.

"Having a bit of an understanding on what's happening to assets or what's likely to happen to the asset values is important."

James says such an eventuality is unlikely in the short term but could become a larger issue in a prolonged recession, especially if everyone rushes for the exits at the same time.

Tomorrow, we'll look at companies that have sturdy financial foundations—balance sheets that can withstand financial shocks.

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.