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Interest cover and possibly other questions about company valuation parameters

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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Interest cover and possibly other questions about company valuation parameters

#142386

Postby TheMotorcycleBoy » May 30th, 2018, 5:42 pm

Hi all,

So in addition to looking at ROCE (got our heads around that), FCF/FCFE (getting there), another figure we are trying to calculate from publicised annual reports is Interest cover.

The concept seems clear, and the formula:

interest cover = EBIT / interest payable

simplicity itself.

But where is the figure interest payable itself disguised in typical reports? Should we look in either the Income Statement, Balance Sheet or the Cash Flow Statement?

as examples I've just looked at Marshalls, and Dominos

https://www.marshalls.co.uk/documents/r ... report.pdf
https://investors.dominos.co.uk/system/ ... s-2017.pdf

This is my best shot so far:

1. In the Income Statement, described as either "Financial expenses" or "Financial costs"
or
2. In the Cash Flow Statement, in the Dominos report the figure looks to be "Interest paid (1.1)" which seems very low, and the marshalls report has no matching entry. (Only Increase/decrease in borrowings, but they are surely principal amounts, not interest payments).

Can anyone help?

many thanks, M&M

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Re: Interest cover and possibly other questions about company valuation parameters

#142420

Postby Gengulphus » May 30th, 2018, 9:05 pm

Melanie wrote:as examples I've just looked at Marshalls, and Dominos

https://www.marshalls.co.uk/documents/r ... report.pdf
https://investors.dominos.co.uk/system/ ... s-2017.pdf

This is my best shot so far:

1. In the Income Statement, described as either "Financial expenses" or "Financial costs"
or
2. In the Cash Flow Statement, in the Dominos report the figure looks to be "Interest paid (1.1)" which seems very low, and the marshalls report has no matching entry. (Only Increase/decrease in borrowings, but they are surely principal amounts, not interest payments).

I generally look at the Income Statement for interest cover - basically, it will contain a "profit before interest and taxation" or similarly-named subtotal, then some extra lines, then a "profit before taxation" or similarly-named subtotal, and the difference between those two subtotals would logically be the "interest". That would make the Dominos "interest" be the net result of the £1.8m finance income and the £1.9m finance costs, i.e. £0.1m, and it would be covered 813 times by the £81.3m profit before interest and taxation.

Properly speaking, that's not "interest cover" but what might be called "net finance costs cover", and I might want to investigate the finance income and finance costs in more detail to see which have the characteristics that make interest cover a figure I want to know - i.e. basically a cost that the company has to pay and is expected to continue to have to pay to have access to a large chunk of money. To do that for Dominos, I would look up notes 9 and 10 (the ones referenced by the "Finance income" and "Finance costs" lines) and I would find that note 10 describes all the finance costs as interest, but note 9 has a "Foreign exchange" line of £1.0m which is neither described as interest nor has the characteristics of interest. So I would adjust the figures to £1.9m of interest paid and £0.8m of interest received, or £1.1m net interest paid. So the interest cover figure would really be 73.9 for net interest cover or 42.8 for gross interest cover (I can see arguments for using either and don't have a firm opinion about which way the decision should go, so I'll leave that decision to you).

I use the word "would" a lot in that last paragraph because I wouldn't actually want to do it for Dominos - I would take one look at the relevant part of the Income Statement, note it down as "very adequately high" and move on to the next thing to check! If I wanted to formalise that in a spreadsheet, I would get the spreadsheet to take the figures for "profit before interest and taxation" and "finance costs" and calculate an "interest cover no lower than" figure as their ratio, on the basis that that's the worst-case figure if all finance costs are interest and no finance income is interest). If that figure is adequately high - say >= 25 - the spreadsheet would use it; if not, it would display a "breakdowns of finance costs and income wanted" message until I'd provided those breakdowns.

Incidentally, that's really an "excessive accuracy creates extra work for no substantial benefit" point. The difference between interest covers of say 100 and 50 may look hugely bigger than the difference between interest covers of say 5 and 4, but what actually matters is what proportion of the company's profit before interest and tax it's paying out as interest. Interest covers of 100, 50, 5 and 4 correspond to paying out 1%, 2%, 20% and 25% respectively of those profits as interest, and so the difference between interest covers of 5 and 4 is actually five times greater than that between 100 and 50, not fifty times smaller. So if you know that the interest cover is greater than 25, you know that the company is paying out less than 4% of its earnings before interest and tax as interest - do you have a need to know the exact percentage more accurately than that that is important enough to justify spending any extra time on it?

I would not use the Cash Flow Statement for interest cover calculations - it would be misleading if e.g. the company borrowed on an interest-accrues-throughout-the-term-of-the-loan-but-is-only-payable-at-the-end basis. I've no real idea how much that happens, but it probably does when a company borrows to get through shortish-term cash flow difficulties. The lender would obviously have to be persuaded that the company will highly probably get through them and would charge quite a high interest rate to compensate for the remaining risk, and the net result would be that just when the company is incurring a high interest liability on its borrowings, its Cash Flow Statement would be showing no interest paid!

One other related point is that even when basing it on the Income Statement, interest cover can be misleading about the company's current debt situation if it has increased its debt level substantially towards the end of the period being reported on, as the Income Statement might only reflect one month's interest on the extra loans taken on but if the loans are of other than short duration, one can expect a full year's interest to be what happens in the future. I see some indications that that has happened with Dominos: in particular, the financial liabilities (current + non-current, but not counting the share buyback obligation which seems unlikely to bear interest) on its balance sheet are £158.5m, £1.9m gross interest payable is a pretty low figure for interest on that amount of debt, and the corresponding financial liabilities figure for the previous year was much lower at £57.7m. To determine whether that has happened would involve investigating what has happened to them during the year, for which my first port of call would be note 24, referenced by the relevant lines of the balance sheet. But even if I owned the shares or was considering buying them, I probably wouldn't do that unless gearing or some other capital-based debt measure suggested that there might be a debt problem - and as it is, one quick skim of note 24 tells me that requires far too much effort for the sake of a post only!

That's not saying that capital-based debt measures are superior to interest cover - there are other situations in which it's the capital-based debt measures that are misleading and interest cover gives a better picture. For example, companies whose cash flow is strongly seasonal and whose debt level moves up and down considerably during the year can produce a pretty low gearing figure if the balance sheet date is when the debt is seasonally lowest - but the interest they pay is going to depend on their average debt level, which may be considerably higher. So it's really an argument for using at least two debt measures, one income-based and one capital-based, and investigating in more detail if they give very different pictures of the company's debt situation.

Gengulphus

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Re: Interest cover and possibly other questions about company valuation parameters

#142606

Postby TheMotorcycleBoy » May 31st, 2018, 5:15 pm

Gengulphus wrote:I generally look at the Income Statement for interest cover - basically, it will contain a "profit before interest and taxation" or similarly-named subtotal, then some extra lines, then a "profit before taxation" or similarly-named subtotal, and the difference between those two subtotals would logically be the "interest". That would make the Dominos "interest" be the net result of the £1.8m finance income and the £1.9m finance costs, i.e. £0.1m, and it would be covered 813 times by the £81.3m profit before interest and taxation.

Properly speaking, that's not "interest cover" but what might be called "net finance costs cover", and I might want to investigate the finance income and finance costs in more detail to see which have the characteristics that make interest cover a figure I want to know - i.e. basically a cost that the company has to pay and is expected to continue to have to pay to have access to a large chunk of money. To do that for Dominos, I would look up notes 9 and 10 (the ones referenced by the "Finance income" and "Finance costs" lines) and I would find that note 10 describes all the finance costs as interest, but note 9 has a "Foreign exchange" line of £1.0m which is neither described as interest nor has the characteristics of interest. So I would adjust the figures to £1.9m of interest paid and £0.8m of interest received, or £1.1m net interest paid. So the interest cover figure would really be 73.9 for net interest cover or 42.8 for gross interest cover (I can see arguments for using either and don't have a firm opinion about which way the decision should go, so I'll leave that decision to you).

Thanks, yes. I got there. I sort of get your remark regarding the forex line not really serving to reduce the £1.9m. So I understand we can now calculate IC to be 73.9. (I am still perplexed however why the entry, i.e. the forex one, is there, presumably they did well in getting a decent forward rate against $ or Euro, realised when £ dropped, but I'm probably vastly overstepping my financial know-how there!).

Gengulphus wrote:I use the word "would" a lot in that last paragraph because I wouldn't actually want to do it for Dominos - I would take one look at the relevant part of the Income Statement, note it down as "very adequately high"...do you have a need to know the exact percentage more accurately than that that is important enough to justify spending any extra time on it?

Totally agree. By either of the above choice of 0.1M or 1.1M of interest DOMs are adequately covered by a large margin.

Gengulphus wrote:One other related point is that even when basing it on the Income Statement, interest cover can be misleading about the company's current debt situation if it has increased its debt level substantially towards the end of the period being reported on, as the Income Statement might only reflect one month's interest on the extra loans taken on but if the loans are of other than short duration, one can expect a full year's interest to be what happens in the future. I see some indications that that has happened with Dominos: in particular, the financial liabilities (current + non-current, but not counting the share buyback obligation which seems unlikely to bear interest) on its balance sheet are £158.5m, £1.9m gross interest payable is a pretty low figure for interest on that amount of debt, and the corresponding financial liabilities figure for the previous year was much lower at £57.7m.

Understood and agreed and many thanks for illustrating (when one is serious in making use of such figures/calculations etc.) the importance of following the notes and determining the reasons for the fluctuation of these datas. (In this case the additional debt for 2017).

Gengulphus wrote:To determine whether that has happened would involve investigating what has happened to them during the year, for which my first port of call would be note 24, referenced by the relevant lines of the balance sheet. But even if I owned the shares or was considering buying them, I probably wouldn't do that unless gearing or some other capital-based debt measure suggested that there might be a debt problem

I'm starting to get a little bit behind here GGP. Firstly when you say gearing, would that be "financial gearing"? Is that when a firm takes on a lot of debt, because that way, the interest on debt is deducted prior to tax, and since interest rate is less than tax rate, the firm can make it's cash flow better?

Gengulphus wrote:one quick skim of note 24 tells me that requires far too much effort for the sake of a post only!

Ok. appreciated. I read it a bit. There are various debt and debt arrangements from various sources at differing rates.

Gengulphus wrote:That's not saying that capital-based debt measures are superior to interest cover - there are other situations in which it's the capital-based debt measures that are misleading and interest cover gives a better picture. For example, companies whose cash flow is strongly seasonal and whose debt level moves up and down considerably during the year can produce a pretty low gearing figure if the balance sheet date is when the debt is seasonally lowest - but the interest they pay is going to depend on their average debt level, which may be considerably higher. So it's really an argument for using at least two debt measures, one income-based and one capital-based, and investigating in more detail if they give very different pictures of the company's debt situation.

Yup. I get it, different parameters can illustrate differing issues or concerns or green lights if all is well.

Now I hasten to add that this is all very very new to me and Mel. i.e. income-based vs. capital-based. So trying not to seem like quite such a newbie, I have just opened the "How to pick quality shares" book again, and in the "How to avoid dangerous companies" summary (I guess he is alluding to "debt-ridden"), he lists the following rules:

1. Debt to Net op. cash flow less than 3 times
2. Debt to FCF less than 10 times
3. Debt to total assets less than 50%
4. Int. cover more than 5 times
5. Fixed charge cover more than 2 times


So making my own, at this present moment, guess; is 3. the only capital-based measure here? And thus 1.,2.,4. and 5. the income-based ones?

Many thanks for your help,
Much appreciated, Matt and Mel

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Re: Interest cover and possibly other questions about company valuation parameters

#142636

Postby Gengulphus » May 31st, 2018, 7:48 pm

Melanie wrote:
Gengulphus wrote:To determine whether that has happened would involve investigating what has happened to them during the year, for which my first port of call would be note 24, referenced by the relevant lines of the balance sheet. But even if I owned the shares or was considering buying them, I probably wouldn't do that unless gearing or some other capital-based debt measure suggested that there might be a debt problem

I'm starting to get a little bit behind here GGP. Firstly when you say gearing, would that be "financial gearing"? Is that when a firm takes on a lot of debt, because that way, the interest on debt is deducted prior to tax, and since interest rate is less than tax rate, the firm can make it's cash flow better?

"Gearing" on its own basically means any financial ratio that measures the company's debt as a percentage of its capital value. There are quite a lot of different definitions, depending on things such as whether you use the company's gross debt or its net debt (i.e. its gross debt with cash & equivalents netted off) and how you choose to measure its capital value: net asset value is a popular one, but so is net tangible asset value (i.e. net asset value minus the value of goodwill and other intangible assets) and there are several others. So the unqualified word "gearing" is a generic term, and if you see someone giving figures for it, always ask yourself the question "what definition of gearing are they using?"...

In the above, however, I was using "gearing" generically. Debt is basically a capital measure - it's essentially 'negative capital', with the interest the company pays on it being some corresponding 'negative income', and so any form of "gearing" as I've described it above is a capital measure divided by another capital measure, and so is capital-based.

It doesn't make any difference to "gearing" why the debt was taken on - it could be for the reason you suggest, it could be to make an acquisition, it could be to recover from an unexpected disaster, etc, and in all cases its direct effect on the "gearing" debt measures will be the same (though there might well also be effects on them from associated events - e.g. the unexpected disaster will probably have decreased the company's capital value and so increased "gearing" debt measures).

By the way, not every qualified use of "gearing" is an instance of that generic meaning of the word. For example, "operational gearing" refers to the phenomenon that a company with large fixed costs will convert a small percentage increase in turnover into a much larger percentage increase in earnings, and so is neither a debt measure nor capital-based!

Melanie wrote:Now I hasten to add that this is all very very new to me and Mel. i.e. income-based vs. capital-based. So trying not to seem like quite such a newbie, I have just opened the "How to pick quality shares" book again, and in the "How to avoid dangerous companies" summary (I guess he is alluding to "debt-ridden"), he lists the following rules:

1. Debt to Net op. cash flow less than 3 times
2. Debt to FCF less than 10 times
3. Debt to total assets less than 50%
4. Int. cover more than 5 times
5. Fixed charge cover more than 2 times


So making my own, at this present moment, guess; is 3. the only capital-based measure here? And thus 1.,2.,4. and 5. the income-based ones?

Sorry, I didn't mean to imply that every debt measure had to be either purely income-based or purely capital-based. Numbers 1 and 2 are ratios of capital measures to income measures and so a mix, 3 is purely capital-based and 4 is purely income-based. I haven't come across "fixed charge cover" and don't have time to educate myself about it right now, but it sounds as though it's probably purely income-based.

As a general rule, I would consider something an income measure if it's about something that accumulated over the financial period being reported on, generally reported in the income statement or cash flow statement or their notes, and a capital measure if it's a 'snapshot' of the state of the company on a particular date, generally reported in the balance sheet or its notes. I suspect there are probably exceptions to those general rules and borderline cases, so don't necessarily take them as absolutely hard-and-fast rules!

Gengulphus

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Re: Interest cover and possibly other questions about company valuation parameters

#142692

Postby TheMotorcycleBoy » June 1st, 2018, 6:16 am

As usual, many thanks for this.

Gengulphus wrote:I haven't come across "fixed charge cover" and don't have time to educate myself about it right now, but it sounds as though it's probably purely income-based.

It's another parameter we've picked up from Phil's book. I'm away from home right now, but if my memory serves me right, it's used as a basic as to how easily a firm can pay / keep up with it's leasing overhead. So (I do believe) it is a measure which is more often applied to high street retailers.

From my memory, and looking at a few online notes I made, I believe that is given by this:

(EBIT + operating lease costs) / (net interest + operating lease costs)

(So yes, you're right - it's income-based).

I'll chew over the rest of what you've written in your last post over the weekend.

thanks, Matt

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Re: Interest cover and possibly other questions about company valuation parameters

#142704

Postby Dod101 » June 1st, 2018, 8:48 am

I have been following these threads from Matt and Melanie with great interest and am not in the least critical but if we could be around in 20 years time it would be great to see the outcome. I wonder if it will make Matt and Melanie better investors?

I assume the intention is so that they can screen shares and pick only those that pass, in the time honoured way. I wonder how many they will find? Depending on how tightly they set the parameters they might end up with Fundsmith, but at least they will have a good idea of how Fundsmith works, and they would probably have avoided Carillion.

Dod

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Re: Interest cover and possibly other questions about company valuation parameters

#142743

Postby TheMotorcycleBoy » June 1st, 2018, 10:46 am

Dod101 wrote:I have been following these threads from Matt and Melanie with great interest and am not in the least critical but if we could be around in 20 years time it would be great to see the outcome. I wonder if it will make Matt and Melanie better investors?

I assume the intention is so that they can screen shares and pick only those that pass, in the time honoured way. I wonder how many they will find? Depending on how tightly they set the parameters they might end up with Fundsmith, but at least they will have a good idea of how Fundsmith works, and they would probably have avoided Carillion.

Dod

You have sussed us out Dod ;)

When we first bought stocks, we were a bit gung ho, I think. We've been ok so far, but we have obviously been buoyed by the fact that the market has grown a tad since March when we started.

Although this post may take this thread briefly off-topic (and I should probably just create a new one called "M&M's first portfolio"), I will briefly digress, and I'll subsequently bring things back on inline in a post or two.

When we first started we bought about 1k of each of the following:

Dominos
Focusrite
Burford capital
Computa center
Marshalls PLC
Advanced Medical Solutions
Unilever

we had done "a fair bit of research". Reasonable growth in revenue, EBIT, sane operating margins etc. etc.

Then we started to focus on dividends and long lived old firms. So bought Legal and General which I actually think is a wise choice. We then considered buying BT, because I'd speculated, the optical fibre outlay and digitising the UK (BT are going ballistic in our rural area, and have been a few years now), would be a "good earner". But then we read about the Italian accounting, the pensions deficit, etc. and got bad vibes. So we bought into another telco: Manx Telecom.

Then on, we strayed off our path a little and probably mixed up quite a few random ideas (basically dividend delivery, diversity, and currently lowish priced?). And we most recently bought Morrisons, National Grid, and IMB.

(We since sold off all our Focusrite, after 19% growth in about 6 weeks).

So what we're trying now (a little bit belatedly) is actually rationalise what we bought. Was it sensible? Was it well priced etc.....I think our main set back was initially buying without enough consideration into the current market price. Marshalls and AMS are still a tad under (only by a couple of % mind), but I still genuinely believe that are decent stocks in their sectors, so we will monitor and cross fingers for now.

Thus the current plan is to get our heads around all these parameters, see how our current of shares look, then finally get a better handle on valuing shares on the market (just started researching that), and then hopefully be a little more strategic in future buys/sells.

Matt (and Mel)

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Re: Interest cover and possibly other questions about company valuation parameters

#142745

Postby TheMotorcycleBoy » June 1st, 2018, 10:48 am

If anyone wants to give any critic, comments to our above stocks, feel free, I will bring the thread back on topic later on.

So long as ok with moderators etc.

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Re: Interest cover and possibly other questions about company valuation parameters

#142759

Postby Dod101 » June 1st, 2018, 11:15 am

Probably best on another thread but I think that is great and although I do not know much about all your initial choices they look good to me and your later ones I think are great. Well done both. Experience in the market is what really counts I think and although we all get things wrong (read any investment book about that!) you will in time at least get more right than wrong which is what really counts. I think you are both amazing being as enthusiastic as to get into all the nitty gritty as you have.

If I do not say it others will; that you need to have an aim, maybe just to increase your capital pot. For a number of us, myself included, it is to provide an income to live off. I have a largish portfolio of mostly income stocks and another smaller one for growth ones. Only if you know what you are aiming for and what you expect from different shares can you judge whether you are getting anywhere. Obvious I know but well worth repeating!)

Best of luck!

Dod

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Re: Interest cover and possibly other questions about company valuation parameters

#142850

Postby simoan » June 1st, 2018, 2:23 pm

Melanie wrote:If anyone wants to give any critic, comments to our above stocks, feel free, I will bring the thread back on topic later on.

So long as ok with moderators etc.

I would completely echo what Dod has said. The only way to improve as an investor is to experience time in the markets with real money at stake. I'm "lucky" enough to have done so through the dotcom bubble, 9/11, great financial crisis, Iraq war etc. Whilst the Phil Oakley book is great, it is very low level and this is why I suggested you maybe read the James Montier and Lee Freeman-Shor books because IMHO there are possibly more important higher level aspects to investing in shares than simply picking good ones and avoiding bad ones. You need to recognise built-in cognitive biases that may effect your decision making and decide how you will react to a quick drop in value of your portfolio, because it will happen. As Dod said, you have to have a strategy and know what it is that you are working towards, as they say "fail to plan, plan to fail".

If you've only started investing in shares this year, then you must realise that we are currently in very benign stock market conditions and to a certain extent "the tide is in and all boats are rising". You may even have missed the selloff at the start of Feb! One of my accounts where I trade slightly more actively in small caps is up 32% YTD and all my other accounts are handsomely beating the FTSE All-share. This kind of out-performance happens occasionally but you mustn't start believing you are some kind of investing genius - I know I am not and that the market has a way of kicking you where it hurts!

In terms of your shares:

Dominos
Focusrite
Burford capital
Computacenter
Marshalls PLC
Advanced Medical Solutions
Unilever

They all look like good quality growth companies (although operating margins of Computacenter are too low for me) and I only currently hold Focusrite. However, I don't quite understand the reason for dabbling with Morrisons, National Grid etc. This seems slightly at odds with your other shares, as you have pointed out yourself, and does not really fit with the same strategy. If you want some equity-based income then with a smallish portfolio I would avoid some kind of very undiversified (dare I mention the term?) HYP and think about parking some money in an ETF like IUKD. This is what I do to generate income in part of my SIPP (yes even I have a HYP!) because it is very liquid with a tight spread, well diversified across 50 high yielding companies, and exempt from stamp duty, plus I can dump it with a single sale if I wish to change tack. Just some thoughts!

All the best, Si

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Re: Interest cover and possibly other questions about company valuation parameters

#142906

Postby TheMotorcycleBoy » June 1st, 2018, 6:15 pm

Dod101 wrote:Probably best on another thread ..

That's a good idea. Thanks for your's and Simon's comments so far. I've a lot to do right now, so I'll probably create a thread for our portfolio in a week or so....and quote in you and Si's remarks....if that's ok.

Anyway from now on, consider this thread "back on the tracks". Will probably reply to what GGP last posted in a day or so....

M&M

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Re: Interest cover and possibly other questions about company valuation parameters

#143172

Postby TheMotorcycleBoy » June 3rd, 2018, 9:32 am

Hi Gengulphus,

Sorry for taking a while for further reply, following on, I've now got a couple more queries on the subject of a firm's debt. Firstly I read your

Gengulphus wrote:There are quite a lot of different definitions, depending on things such as whether you use the company's gross debt or its net debt (i.e. its gross debt with cash & equivalents netted off)

and this does make complete sense, and presumably I would glean this information (i.e. debt) from the firm's Balance Sheet, and that the figures would be available as gross values as they are invidual entries.

So am I indeed right that I'd derive a measure of gross debt (initially) from the "Non-current liabilities" Balance sheet? If so, (this is the relevant section from DOMs 2017 AR linked I above, transposed) which of the sub-entries below would be actual figures to sum....

Non-current liabilities
------------------------------
Trade and other payables (0.9)
Financial liabilities (152.3)
Deferred income (6.8)
Deferred tax liabilities (7.8)
Provisions (13.3)

...in order to arrive at gross debt figure - assuming of course that my guess was right that this is where the debts are on the annual report.

Gengulphus wrote: and how you choose to measure its capital value: net asset value is a popular one, but so is net tangible asset value (i.e. net asset value minus the value of goodwill and other intangible assets) and there are several others.

I understand this conceptually, but I'm struggling on a couple of things. I've just read that goodwill is when a purchase (or sale I guess) occurs for an advantageous price. So presumably a firm acquires an asset which should be priced at £20, for only £15...but it lists it's value is the BS as £20? Is that correct? So, another assumption, presumably you can't meaningfully deduct any such figure for your calculations, unless the firm's BS actually itemises an entry called exactly that; i.e. goodwill.

My second query regarding net asset value and net tangible asset value now has me referring to DOMS 2017 AR. I curious as to how we can derive such a NTAV from these figures (sorry if I've omitted something crucial, I just thought my transposition would save others from scrolling down on the online PDF). So...

Non-current assets
-----------------
Intangible assets 114.2
Property, plant and equipment 105.9
Prepaid operating lease charges 3.5
Trade and other receivables 25.2
Net investment in finance leases 0.5
Available-for-sale financial asset 9.0
Investments in associates and joint ventures 27.3
Deferred tax asset 8.3

Current assets
--------------
Inventories 8.4
Trade and other receivables 48.7
Net investment in finance leases 0.9
Cash and cash equivalents 29.0

Total assets 380.9
......
......
Total liabilities (316.4)
......

Net assets 64.5

So given the above figures what adjustments should be made to the NA figure of 64.5 in order to arrive at the appropriate NTAV?

Sorry about another barrage of questions!
All help gratefully received, Matt and Mel

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Re: Interest cover and possibly other questions about company valuation parameters

#143344

Postby Gengulphus » June 3rd, 2018, 8:49 pm

Melanie wrote:So am I indeed right that I'd derive a measure of gross debt (initially) from the "Non-current liabilities" Balance sheet? ...

No, you need to look at the "Current liabilities" as well, otherwise you miss things like overdrafts (loans that the bank can demand back at any time) and loans whose repayment date has become less than a year away.

Basically, look through all the liabilities on the balance sheet and identify the ones that are currently accruing interest or are expected to start doing so: they're the debt. So loans from banks are debt, bonds the company has issued are debt, trade payables are not (they might start accruing interest if left unpaid for too long if the contract under which they're payable says so, but they're not expected to be left unpaid that long), provisions are not (they're money the company thinks it is likely to have to pay in future, but it's not yet certain when, and may not even be certain that it will ever have to be paid). After gaining a bit of experience researching a few companies, you should start to recognise the things that are and aren't debt, and only need to check in more detail when you encounter something new to you. In Domino's case, my experience would suggest that the two items called "Financial liabilities" are debt, the one called "Financial liabilities – share buyback obligation" probably isn't (the word "obligation" doesn't suggest interest is accruing, but I'm by not entirely certain of that - it's something I either haven't come across before or so rarely / long ago that I don't remember), and the others aren't.

But a useful technique is simply to search the report for the word "debt". Often you'll find the company's own calculation of it from balance sheet items, which is a good starting point... You might want to sanity-check the balance sheet items they don't include to check whether you think they should be included - but when in the past I've tried to do the calculation myself and then checked against the company's calculation, the discrepancies I've discovered are more often things I've overlooked and the company has included than the other way around!

In Domino's case, they don't give a calculation but do give a "net debt" figure of £89.2m. The two "Financial liabilities" items minus "Cash and cash equivalents" total £152.3m+£6.2m-£29.0m = £129.5m. That's a big difference, which I would investigate - and on investigating note 24 about the "Financial liabilities", I find they include two items called "Gross put option liabilities" that total £34.7m+£5.6m = £40.3m and don't look as if interest is accruing on them. Excluding them reduces the £129.5m from my calculation to £129.5m-£40.3m = £89.2m, and the equivalent calculation on the 2016 comparatives gives their comparative "net debt" figure of £34.6m, so I think I've probably worked out what Domino's calculation was!

Melanie wrote:
Gengulphus wrote: and how you choose to measure its capital value: net asset value is a popular one, but so is net tangible asset value (i.e. net asset value minus the value of goodwill and other intangible assets) and there are several others.

I understand this conceptually, but I'm struggling on a couple of things. I've just read that goodwill is when a purchase (or sale I guess) occurs for an advantageous price. So presumably a firm acquires an asset which should be priced at £20, for only £15...but it lists it's value is the BS as £20? Is that correct? ...

In accounting terms, goodwill arises specifically on acquisitions of other companies: it is the amount paid for the acquisition minus the identifiable book value of its assets. The idea is basically that the acquirer have paid a fair price for the acquisition, so if e.g. the acquirer has paid £100m for the acquisition and the assets it has have a total book value of £60m, then the fact that it has the ongoing business it does must be worth a further £40m of 'goodwill'. It's a reasonable idea in principle, but IMHO has at least two problems in practice. First, companies have rather too frequently been known to overpay for acquisitions and occasionally snap up a bargain, i.e. underpay for them. Including 'goodwill' in net asset value results in the overpaying company's net asset value being too high and the underpaying company's net asset value too low, which means that figure calculated for the overpaying company's gearing is too low and that for the underpaying company too high. Since lower gearing is better, that produces a bias in favour of companies that have overpaid for acquisitions in the past and against ones that have underpaid, which is not what I want: gearing is supposed to be a capital-based "snapshot" of the company's state on a particular date and so not to be biased by what the company has done previously, but if it's got to have such a bias, I want it to favour companies with good past records over ones with poor past records! (That problem is mitigated by the accounting rules about goodwill impairment reviews: they basically say that goodwill must be regularly reviewed for being a reasonable value of the associated ongoing business, and if that reveals that it's overvalued then the balance sheet value of the goodwill must be impaired, i.e. reduced. But it's not mitigated very well because valuing the ongoing business is not an exact science, and directors are reluctant to impair goodwill because the impairment reduces earnings on the income statement, so the mitigation tends to only happen when it becomes pretty glaringly obvious that the ongoing business is overvalued...)

Secondly, accounting goodwill never arises from organically growing subsidiaries, only from acquiring them. So two currently-identical companies that only differ in that in the past, company A acquired its subsidiaries and company B started them up and grew them organically, will have balance sheets that include goodwill assets for company A's subsidiaries and not for company B's subsidiaries, while they'll have identical liabilities and non-goodwill assets. So two companies in exactly the same current state could have very different net asset values, even if everything on the balance sheet is fairly valued. That difference is basically due to the fact that the fair values of the ongoing businesses of company A's subsidiaries is on the balance sheet, while those for company B are not. So that produces a net asset value bias in favour of company A, when I'd want them to be equal on net asset value (and again, if there has to be a bias, I'd want it to be in favour of company B - organically-grown businesses are less likely to suffer bedding-in problems than acquired ones...).

Melanie wrote:So, another assumption, presumably you can't meaningfully deduct any such figure for your calculations, unless the firm's BS actually itemises an entry called exactly that; i.e. goodwill.

If you want to calculate net tangible asset value (NTAV), subtract anything on the balance sheet called "Intangible assets", "Goodwill", "Other intangible assets" or similar (there are minor variations between companies about the exact naming of most balance sheet items, though not many about these particular items). "Goodwill" and "Other intangible assets" tend to appear in pairs, in that order, and when "Intangible assets" appears on its own, it usually points to a note that breaks them down into categories, goodwill being one of them.

In your example of Domino, net asset value is given on the balance sheet as £64.5m and "Intangible assets" as £114.2m, so NTAV = £64.5m-£114.2m = -£49.7m is negative. When the 'capital value' figure in a 'debt' / 'capital value' gearing calculation is negative, the resulting figure is very misleading, a situation called 'negative equity'. So if you use net debt as the 'debt' figure, for instance, Domino's net gearing is £89.2m/£64.5m = 138% based on NAV but 'negative equity' (rather than a percentage) based on NTAV.

Some people (I'm one of them) prefer to automatically ignore only goodwill, and take a considered view of other intangible assets. So for example, a look at note 15 shows that goodwill is only £49.7m out of the £114.2m intangible assets, so Domino's net gearing is £89.2m/(£64.5m-£49.7m) = 603% based on NAV excluding goodwill. (That's not a statement that I wouldn't exclude the three other categories of intangible asset in note 15, by the way - I might or might not decide to if I were to consider the question.)

Gengulphus

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Re: Interest cover and possibly other questions about company valuation parameters

#143506

Postby TheMotorcycleBoy » June 4th, 2018, 11:23 am

Hi Gengulphus,

I've had a very quick skim read of your post above just now at work, but it will take me an evening or two to do it justice. I'll probably post back then, but for now, many thanks for spending the time to put pen to paper and explain what you have done so far!

Matt and Mel

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Re: Interest cover and possibly other questions about company valuation parameters

#143526

Postby Dod101 » June 4th, 2018, 12:01 pm

Gengulphus's comments re the treatment of Goodwill is very pertinent and he has drawn attention to some of the silly situations that nowadays arise when trying to value a company. Goodwill, like property revaluations, is essentially a capital item and I do not think should go through the P & L account but be adjusted in the Balance Sheet. If I had my way, I would not allow any goodwill on a balance sheet but require it to be written off on acquisition (which would get around the point that G has made re organic growth v growth by acquisition).

Likewise for property companies, if they must revalue their investment properties every year, deal with the adjustment through the balance sheet and leave the P & L account for true revenue. Currently, revenue reserves (or retained earnings as they are sometimes called) will include the revaluation of investment properties. They are not distributable and so it is completely misleading. Take a look at say British Land's accounts to see what I mean.

Digging into company accounts is not easy.

Dod

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Re: Interest cover and possibly other questions about company valuation parameters

#143671

Postby TheMotorcycleBoy » June 4th, 2018, 5:55 pm

Gengulphus wrote:But a useful technique is simply to search the report for the word "debt".

Of course. Typical of me to miss the obvious. Though having said that there is so much fluff in a lot of the reports that it's easy to overlook. Thanks for the simple tip!

Gengulphus wrote:In Domino's case, they don't give a calculation but do give a "net debt" figure of £89.2m. The two "Financial liabilities" items minus "Cash and cash equivalents" total £152.3m+£6.2m-£29.0m = £129.5m. That's a big difference, which I would investigate - and on investigating note 24 about the "Financial liabilities", I find they include two items called "Gross put option liabilities" that total £34.7m+£5.6m = £40.3m and don't look as if interest is accruing on them. Excluding them reduces the £129.5m from my calculation to £129.5m-£40.3m = £89.2m, and the equivalent calculation on the 2016 comparatives gives their comparative "net debt" figure of £34.6m, so I think I've probably worked out what Domino's calculation was!

Well done and thanks. Us newbies actually had to look up "put option" to figure out what it all meant. And then from the AR (note 24) itself, it becomes clearer

Gross put options liabilities
On acquisition of Pizza Pizza EHF and DPN, and the subsequent hive out of PPS Foods AB, a liability at the present value of the gross
amount of the put options held by the non-controlling interests over the remaining shareholding has been recognised on consolidation
amounting to £34.8m and by 31 December 2017 has been revalued to £34.7m.


I thought it was a bit of a swizz at first. But reading on, it seems they are squeaky clean:

The options are exercisable from 1 July 2019 until 30 June 2020.

Dod101 wrote:Digging into company accounts is not easy.

Indeed. See above!

PS. Will process more of GGPs post tomorrow evening.

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Re: Interest cover and possibly other questions about company valuation parameters

#143742

Postby Charlottesquare » June 4th, 2018, 8:18 pm

Really interesting thread.

There is of course much more than property revaluations flying through an I & E , whilst I would not know where to start these days preparing quoted company accounts, I presume under IFRS, a brief read of the more basic say FRS102 and measuring financial instruments will give a flavour.

https://www.frc.org.uk/getattachment/e1 ... y-2015.pdf

Take a look at 11 and 12 and weep, imho property revaluations are the least of one's worries re weird I & E adjustments. ( This is a general point not re Dominos)

One other useful metric (though not really with Dominos who have a revolving credit) is just have a glance at financial liabilities due in one year, where debt has installments re repayment interest cover only takes you so far, if you say compare operating cashflow instead (may eliminate some of the fair value adjustments) tweaked re recurring bits (tax etc) with say interest, capital repayments due in one year, dividends and normal capex you may get a better feel.This is far more significant with companies with large assets/large debts, like property companies.

Dominos 2017 cashflow (P81) had a £396 million new inflow re debt and a repayment of £339m, net inflow of £57m as also reflected in non current debt at £113.9 (£53.7) re the RC ,this covered a good chunk of its acquisitions/share buy back etc, and it does, per the liability note appear to have extended the RC term and have headroom re same, but at the end of the day it is not really repaying debt and this does need considered; breaking down the cashflow to ensure at an operating level it washes its face is important as debt ceilings do get reached and different banking environments in future do need considered.(renewals in a hostile climate, like post 2008, were not plain sailing)

Allowing the depreciation/amortisation charge as a proxy re recurring required capital spend it crudely brought in circa £104m, spent £47m on divs and £37 on own shares, if recurring stand still capex is say £14 (guess) and as £18 of the £104 was flexing working capital (cannot repeat each year) it is tight if the share buy back is to be continuing (no idea if it is) Of course the acquisitions ought to be earnings/cashflow enhancing (see note 31) but to me if they do intend to continue both share buy backs and acquisitions then debt will likely increase.

This does mean trying to wade through the cashflow discerning those that are operationally recurring items and those that are one off amounts, never an exact science ( especially plant/acquisitions, really tricky to know what is expansion and what is status quo expenditure though if a more established/stable business recurring trend can be estimated), however it can give some clue that there are possible issues ahead.

As an aside ,re tricky bits, trust you noticed the undisclosed interest in note 16

"Capitalised financing costs
Included within freehold land and buildings is an amount of £1.1m (2016: £1.0m) of capitalised financing costs relating to the revolving
credit facility used to finance the building of the new Supply Chain Centre. Tax relief on capitalised interest is claimed in full in the period
in which the interest is paid."

So the I & E interest used re interest cover calculation is missing £0.1m re the year (£1.1-1.0) as this was added to the asset carrying value, not significant in this instance but does show you really have to dig deep to find all the little bits and why sometimes the cashflow statement can be safer, items are trickier to lose in there as against the I & E, not really here a problem but does reinforce the dangers of the I & E, it is only as good as what has been included.

None of above are any indictment of Dominos, they are more to point out that quoted company accounts are tricky things.

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Re: Interest cover and possibly other questions about company valuation parameters

#143835

Postby TheMotorcycleBoy » June 5th, 2018, 6:29 am

Gengulphus wrote:In accounting terms, goodwill arises specifically on acquisitions of other companies: it is the amount paid for the acquisition minus the identifiable book value of its assets. The idea is basically that the acquirer have paid a fair price for the acquisition, so if e.g. the acquirer has paid £100m for the acquisition and the assets it has have a total book value of £60m, then the fact that it has the ongoing business it does must be worth a further £40m of 'goodwill'. It's a reasonable idea in principle, but IMHO has at least two problems in practice. First, companies have rather too frequently been known to overpay for acquisitions and occasionally snap up a bargain, i.e. underpay for them. Including 'goodwill' in net asset value results in the overpaying company's net asset value being too high and the underpaying company's net asset value too low, which means that figure calculated for the overpaying company's gearing is too low and that for the underpaying company too high. Since lower gearing is better, that produces a bias in favour of companies that have overpaid for acquisitions in the past and against ones that have underpaid, which is not what I want: gearing is supposed to be a capital-based "snapshot" of the company's state on a particular date and so not to be biased by what the company has done previously....

Ok, thanks again for this. That casts this term "goodwill" in new light for me. I had a good think about this one, I think that to an extent does it not make the whole concept of "book value of (existing) assets" some what arbitrary? Myself and my colleagues are software engineers. Were our team to be acquired, indeed the acquirer could pay 100 units for us, where 60 of those are recognised as book value of PCs, books, licenses, furniture etc. and 40 of goodwill. But surely the 60 is only a useful value if the acquirer is to sell those items? Their book value, IMO, seems meaningless in the context of how much revenue it can generate in the future without having any of those tangible/intangible items renewed.

Gengulphus wrote: but if it's got to have such a bias, I want it to favour companies with good past records over ones with poor past records!

Yes that's tricky. Because presumably, in terms of mercenary ruthlessness, the better/more successful acquirer will presumably have driven a harder bargain and acquired for lower price, thus less increment to asset side, hence raised his gearing measure?

Gengulphus wrote:Secondly, accounting goodwill never arises from organically growing subsidiaries, only from acquiring them. So two currently-identical companies that only differ in that in the past, company A acquired its subsidiaries and company B started them up and grew them organically, will have balance sheets that include goodwill assets for company A's subsidiaries and not for company B's subsidiaries, while they'll have identical liabilities and non-goodwill assets. So two companies in exactly the same current state could have very different net asset values, even if everything on the balance sheet is fairly valued. That difference is basically due to the fact that the fair values of the ongoing businesses of company A's subsidiaries is on the balance sheet, while those for company B are not. So that produces a net asset value bias in favour of company A, when I'd want them to be equal on net asset value (and again, if there has to be a bias, I'd want it to be in favour of company B - organically-grown businesses are less likely to suffer bedding-in problems than acquired ones...).

Thanks, yet another twist to the tale....

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Re: Interest cover and possibly other questions about company valuation parameters

#143871

Postby TheMotorcycleBoy » June 5th, 2018, 10:17 am

Hi Charlotte,

I may have the wrong end of the stick here, but does what you had said here:

Charlottesquare wrote:Capitalised financing costs
Included within freehold land and buildings is an amount of £1.1m (2016: £1.0m) of capitalised financing costs relating to the revolving
credit facility used to finance the building of the new Supply Chain Centre. Tax relief on capitalised interest is claimed in full in the period
in which the interest is paid."


relate to an earlier one of mine?
viewtopic.php?p=142692#p142692

which was my very crude recollection of how in Phil Oakley's "How to pick quality shares", Phil presents a parameter called fixed charge cover to measure ability of a firm to pay it's lease costs.

In his calculation the attribute

operating lease costs

IIRC is the capitalised value of annual lease cost. He states that can either be deduced by a discounting process or simply multiplying annual cost by 7.

When people say:
Charlottesquare wrote:like property companies.

Do they mean firms like British Land, or do they just mean retailers, i.e. lots of property owning/leasing for their business.

many thanks
Matt

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Re: Interest cover and possibly other questions about company valuation parameters

#143967

Postby Charlottesquare » June 5th, 2018, 6:16 pm

Melanie wrote:
Ok, thanks again for this. That casts this term "goodwill" in new light for me. I had a good think about this one, I think that to an extent does it not make the whole concept of "book value of (existing) assets" some what arbitrary? Myself and my colleagues are software engineers. Were our team to be acquired, indeed the acquirer could pay 100 units for us, where 60 of those are recognised as book value of PCs, books, licenses, furniture etc. and 40 of goodwill. But surely the 60 is only a useful value if the acquirer is to sell those items? Their book value, IMO, seems meaningless in the context of how much revenue it can generate in the future without having any of those tangible/intangible items renewed
.]

You are thinking worth here re resale, what you need to think is worth to the business. Any fixed asset addition gives a philosophical choice, do we measure its "value", what we can sell it for, or its utility to us? Accounting re plant tends to take the latter viewpoint,the balance Sheet re this is less a reflection of its value and more a carrying pouch, someplace to place the asset whilst it gets used (consumed) by the business.

A somewhat old style definition of depreciation is thus,

"The fundamental objective of depreciation is to reflect in operating profit the cost of use of the tangible fixed assets (ie the amount of economic benefits consumed by the entity) in the period. Therefore, the depreciable amount (ie cost, or revalued amount, less
residual value) of a tangible fixed asset should be recognised in the profit and loss account on a systematic basis that reflects as fairly as possible the pattern in which the asset’s economic benefits are consumed by the entity, over its useful economic life"

There has been all my life in accounting (mid 80s onwards but probably longer ) a conflict between the primacy of the profit and Loss (Income and Expenditure) and the Balance Sheet, if I throw fixed assets into a balance sheet at what I can sell them for then I may better measure worth of business re assets in use but understate "real" future contribution the assets make, in effect overstate my profits as the charge the asset makes for its use to the business is reduced.

Company has a XY machine it bought new for £1,000, 10 year life and it depreciates it at £100 per year, now 5 years old and NBV £500.
It then takes over Company B that by chance also has an XY machine that is 5 years old, cost company B £1,000, has a NBV in Co b of £500 but a resale value of only £100, though will contribute 5 more years work. So how do I bring it, and goodwill, in on acquisition, do I say it has net future benefit to my business of £500 over the next 5 years or no,its resale is only £100, that is correct figure? If resale figure where is the logic that I have one 5 year old machine at £500 and one at £100, both adding same vale, one re depreciation costing £100 per year one £20, how "real" are my reported profits?

The FRS 102 standard fudges around this conflict re what it is trying to do and whilst I know FRS102 is not on point re quoted companies, who usually report under IFRS, as I am more familiar with it I cite it as an example of the "woolly" nature of what accounts are trying to do; have a read at section 2 , Concepts and Pervasive Principles, and you get the jist, if you get hooked read it all, riveting stuff. :D

https://www.frc.org.uk/getattachment/69 ... March-2018).pdf


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