Dod101 wrote:They are simply indulging in a bit of financial engineering. Not all debt is bad and it may be that at the moment interest on the debt is so low that it would be silly not to have some or even maintain it at current levels (as a percentage of net assets say) Obviously as you know, if a company can make more money from investing borrowings than the cost of borrowing that may be a perfectly good way to finance the company.
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I would take a good look at the Annual Report and see what they have to say to justify what they are doing. Actually just done that. They say the special reflects their desire to 'maintain an efficient Balance Sheet' That is basically what I said above. ...
Indeed, but I'd recommend treating use of the phrase "efficient balance sheet" (by any company, not by any means just this one) as containing a large element of spin. The spin is that efficiency sounds unreservedly good, but taking on debt is definitely not unreservedly good...
If I wanted to spin it the opposite way, I might use a phrase like "crumbling cliff-edge balance sheet". Specifically, standing near the edge of a cliff can be rewarding, but if the edge is crumbling, there's a danger that you're standing on a piece when it crumbles, resulting in anything from just having to scramble your way rather laboriously back to safety through various degrees of injury to a fatal outcome... And the closer you stand to the edge, the smaller and more likely the bit of crumbling needed to cause such things to happen.
Dropping the analogy, the "crumbling" associated with debt has two main forms: the company's earnings declining as a result of 'challenging' trading conditions, unexpected cost increases or such like, and interest rates rising (which might not affect the company for some time if it's taken on the debt at a fixed rate, but will eventually if it cannot pay off the debt by the time it matures because it will then have to borrow again at prevailing interest rates (*)). They also tend to feed off each other in various 'vicious circle' ways - for instance, higher interest rates mean more interest subtracted from trading profits and so lower earnings, lower earnings cause the company's credit rating to drop so that it can only get loans at higher interest rates, or even cause it to fail to meet loan covenants, allowing a now-low-rate fixed-rate loan to be called in prematurely and have to be refinanced at a higher rate earlier than expected. A company can find itself in serious trouble quite quickly if those vicious circles are allowed to develop...
To be clear, I'm
not presenting "crumbling cliff-edge balance sheet" as a superior alternative to "efficient balance sheet": it's just as bad IMHO, just in the negative-spin direction rather than positive-spin. The view one should take should look at debt
both from the point of view of it increasing profitability (provided it's taken on at a sufficiently low interest rate, but that isn't usually a problem for debt taken on when times are good)
and from the point of view of it increasing risk. Various ratios such as gearing, interest cover and debt multiple give rather crude measures of that risk, or one can do more detailed studies such as looking at the debt maturity profile to get a somewhat less crude picture of it. (Though don't expect to get anything really precise from company accounts alone, since more widely-based factors such as downturns in the company's market and government interest rate policy are likely to affect it...)
So basically, I think it's a good idea to treat company claims of having an efficient balance sheet as warnings that it
might have an over-efficient balance sheet that carries excessive risk, raising the question of whether it does. Not a particularly natural question, since there simply isn't such a thing as being over-efficient for many uses of the word - but there definitely is for its use to describe balance sheets.
(*) Or do an equity fundraising such as a rights issue, open offer or placing - but that tends to be hard or even impossible for a company that is struggling.
Gengulphus