How to assess a company’s debt load
BHP is used as an example to show how to assess the impact of too much debt on financial risk and flexibility.
If you research and select your own shares, checking if a company is in a strong financial position is an important step. Assessing if a company’s debt load is sustainable is the key to understanding the overall financial position of the company. Taking on too much debt is a common way for companies to get into trouble - but exploring the amount of debt a company is carrying is about more than protecting your downside.
Challenging economic periods often provide chances for companies with financial flexibility to create value for shareholders. Berkshire Hathaway using its “lender of last resort” status to scoop up cheap equity and credit assets during the Great Financial Crisis is a classic example.
In this article, you’ll learn four ways to assess a company’s debt load. To do this, we’ll use the Balance Sheet, which records what a company owns (assets) and owes (liabilities) on a certain date. We’ll also use the Income Statement, which records a company’s sales and profits over a period of time. Qualitative measures will provide context.
We’re going to use the financial statements of mining heavyweight BHP (ASX: BHP) as an example. I chose BHP because it carries a fair amount of debt and operates in a cyclical industry, which makes it more challenging to support high debt levels given the unpredictability of earnings.
If you’d like to follow along, I’ll be using BHP’s 2023 annual report. The balance sheet is on page 134 and the income statement is on page 133. You can find the 2023 BHP annual report here.
First things first – how much debt?
Let’s start by using BHP’s Balance Sheet to see how much debt they have in absolute terms. To do this, I will add together their short- and long-term borrowings to get total borrowings. I’ll then subtract cash and cash equivalents from this amount to get net debt. If BHP used all of their cash to reduce debt the net debt is what remains.
Net Debt = Total Borrowings – Cash and Equivalents
If this is a negative number, the company has more cash than debt. This is called a net cash position and it means you don’t need to worry about the company’s debt load. BHP did not have net cash as of June 30th 2023.
In US dollars, their 2023 annual report shows $9.89 billion of net debt ($22.35 billion in total borrowings - $12.46 billion in cash and cash equivalents). That is a big number. But without context, it’s just a number.
To assess if BHP can sustain this amount of debt, we’re going to use two simple ratios.
Leverage
Leverage compares a company’s Total Assets to the Shareholders Equity on their Balance Sheet. In other words, how big a role does debt play in the company’s current financial position? Before we dive into calculating it, here’s a quick reminder of the equation behind every Balance Sheet:
Assets = Liabilities + Shareholder’s Equity
To get our head around this, let’s ignore companies for a second and think about a new homeowner.
Let’s imagine they have bought a $1,000,000 house, funded with a $100,000 deposit and a $900,000 home loan. On the day of their purchase, the homeowner’s balance sheet would be:
$1,000,000 in total assets (the house at cost value) = $900,000 total liabilities (the home loan) + $100,000 equity (the deposit).
If the homeowner pays off $50,000 in year one, their new balance sheet would be:
$1,000,000 in total assets (the house at cost value) = $850,000 total liabilities (the remaining loan) + $150,000 equity (their deposit + payments).
Similarly, the equity on a company’s balance sheet is found by subtracting total liabilities from total assets. Calculating leverage lets us compare this equity to the amount of assets controlled by the company. The higher this number, the more of the company’s assets are funded by debt.
Leverage = Total Assets/Shareholder’s Equity
As of June 30th 2023, BHP had Total Assets of $101.29 billion compared to $44.49 billion of equity attributable to shareholders. This means they had leverage of around 2.3x. If BHP were the owner of the $1 million house from our earlier example, their balance sheet would be:
$1,000,000 in total assets (the house value at cost) = $679,679 in total liabilities (the remaining home loan) + $370,370 in equity.
There aren’t any hard rules about what a good or bad amount of leverage is. It can be useful, though, to compare it to that of similar companies. Choosing companies that really are similar can be hard. Glencore, for example, didn’t make the cut here because its trading business means it has a very different balance sheet to other mining majors.
BHP has similar leverage to its peers. This is good to know, but I wouldn’t say we’re much closer to forming an opinion on whether BHP’s debt level is sustainable. What if every company in the sector is using too much debt? The next couple of techniques should help us get a clearer picture.
Interest coverage
As well as the total amount of debt, we need to consider how easily the company can service the cost of that debt. To do this, we are going to compare BHP’s interest expense to their earnings before interest and taxes (EBIT).
This is like a bank checking your mortgage application. Or in my case, a letting agent checking my rental application. What is my income and how does it compare to the contracted outgoings?
Because we are considering what the company earns, we are going to use the Income Statement to get this information. The formula we are going to use for interest coverage is:
Interest Coverage = EBIT/Financial Expenses + Capitalised Interest
While there are no set rules about what level of interest rate coverage is good or bad, a bigger number is better. Let’s work through it for BHP.
As of June 30 2023, BHP’s Interest Coverage was 10.18 ($23.73 billion/$2.33 billion). If I was applying for an apartment and my salary was 10x higher than the rent payment, I’d expect my application to be successful. For more context, though, let’s check BHP’s interest coverage against its peers.
Again, BHP looks well placed here, though it’s important to review these numbers over a few years as the numbers can bounce around a bit. If you remember the Berkshire Hathaway example from earlier, we’d ideally like companies we own to have more flexibility than the competition.
While we now have a good idea of BHP debt load versus peers, we still need to compare the level of debt to the nature of the business itself. To do this, we’re going to use a non-financial measure I’ve coined “Interest Cover to Uncertainty”.
Interest cover to uncertainty
Your job here is to answer a simple question. Given how uncertain the company’s future earnings are, does the level of interest coverage seem reasonable?
In theory, companies with more predictable future results should be able to sustain more debt without worrying their creditors. At Morningstar, our analysts assign an Uncertainty rating to each company they research. A low level of uncertainty means that the outcomes are more predictable.
Coke (NYSE: KO), for example, currently has a “Low” uncertainty rating. It has a wide and firmly established product range that is sold worldwide at a low cost to consumers. Because of this, their earnings are less likely to rise or fall by a huge amount in any one year. A company that depends mostly on a single product, market or growth project has a much broader range of outcomes.
All things being equal, the more uncertain a company’s outcomes are, the more interest coverage you’d like to see. So what about BHP?
Our analysts have given BHP a “Medium” Uncertainty rating. As a mining company, it operates in a cyclical industry and its earnings are affected by commodity prices that it can’t control. On the other hand, BHP is diversified across several commodities and their major assets are established, producing mines. If BHP was reliant on a single commodity or a new mine still under exploration it would impact the Uncertainity rating.
Even if the mining industry’s cyclical nature leads to less certain results, I think BHP’s interest coverage of around 10x looks comfortable. Our analysts also highlighted BHP’s “strong and relatively conservative” balance sheet as part of their discussion on the company’s capital allocation.
By this point, we’ve sized up BHP’s debt load. We’ve also compared it to BHP’s peers and, just as important, to the uncertainty of BHP’s business. But we are missing a vital piece of information – when is the debt coming due?
Timing is everything
You will find a maturity schedule for the company’s debt in the account footnotes. For BHP, I found it on page 170 of the 2023 annual report.
As I write this in 2024, a big chunk of BHP’s debt isn’t coming due until at least 2029. That sounds like a good thing. The other thing I noticed is the large percentage due in “under one year or on demand”. This might be short-term banking facilities like overdrafts. But to check that near-term liabilities aren’t a major issue, I’ll calculate BHP’s current ratio. How easily could BHP pay bills and debts it may be asked to pay within a year? A higher number is better as it means more breathing room.
Current Ratio = Current Assets/Current Liabilities
In their 2023 annual report, BHP listed Total Current Assets of $23.35 billion compared to Current Liabilities of $19.04 billion. $23.25 billion/$19.04 billion gives a current ratio of 1.23.
At the time, BHP’s current ratio was lower than its peers. But as with any financial measure, it’s important to look over a longer period. This is especially true for balance sheet metrics, as they capture the company’s financial position at a single moment in time (the moment the reporting year ends).
Looking back several years, BHP’s current ratio has spent a lot of time closer to the numbers shown by Rio Tinto and Anglo American above.
I don’t personally own BHP. But if I was considering purchasing the shares, I wouldn’t be too concerned by what I see here – or by any of the information I’ve uncovered.
The aim of these techniques is to get a gut feeling about whether a company’s debt load looks sustainable or not. You might be surprised to see those words in an article on fundamental analysis. But if you don’t feel comfortable with the business you are considering an investment in, you will probably struggle to hold it long term.
On the downside, you want to ensure that a company hasn’t taken on more debt than is safe. On the upside, you’d ideally like a company that is strong enough to take opportunities that are presented to them during downturns. I hope the techniques I’ve covered will help you answer these questions next time you study a company.