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Learning about capital-based debt measurement techniques

Melanie
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Learning about capital-based debt measurement techniques

#145670

Postby Melanie » June 14th, 2018, 8:13 pm

Hi everyone,

I am trying to learn more about "capital based" debt measurements. As many here already know, I have discovered that there are several. What's more confusing is that the most popular term, "debt ratio" seems to get overloaded sometimes - most of the time, the ratio debt/assets tends to be used, but I did also find just here:

https://www.ukvalueinvestor.com/2014/11 ... nies.html/

someone stating that this ratio to be debt/profit after tax.

To avoid confusion I'm going to focus on the more frequently used debt/assets method. However even this simple ratio, it seems, can be interpreted in different ways, depending on whether net or gross variants of those two measures are used, but I plan to talk about those in a later post.

The definition, I currently believe to be the most popular (I stand to be corrected), seems to be this:

gross debt/total assets

where "gross debt" is the sum of all "interest bearing" items in the current and non-current liabilities sections. Where as "total assets" is less discriminatory and is really non-current assets + current assets. This is what I want to understand better in this post.

From Phil Oakley's book "How to pick Quality shares", he exemplifies Dominos position in their y/e of 2015. This is a trimmed down version of their balance sheet for that period:

(All values in £000s)
------------------------------------------------------
Total assets 185,446
------------------------------------------------------
Current liabilities
Trade and other payables (52,912)
Deferred income (4,312)
Financial liabilities (988) *
Deferred and contingent consideration (2,865)
Current tax liabilities (4,151)
Provisions (6,113)
------------------------------------------------------
Non-current liabilities
Trade and other payables (316)
Financial liabilities (11,450) *
Deferred income (3,334)
Deferred and contingent consideration -
Deferred tax liabilities (115)
Provisions (1,215)
------------------------------------------------------

In Phil's book, he states At the end of 2015 Domino's had £12.4m of total borrowings and £185.4m of the total assets, giving a very low debt to total assets ratio of 6.7%.

So indeed Phil sums only the liability items which I've starred, i.e. the interest bearing ones.

I'm now going to attempt a similar calculation using NextPLC's consolidated balance sheet for 2014-15.

(All values in £M)
------------------------------------------------------
Total assets 2,282.3
Current liabilities
Bank loans and overdrafts 17 (2.8) *
Trade payables and other liabilities 18 (636.5)
Dividends payable 8 (73.9)
Other financial liabilities 19 (109.4)
Current tax liabilities (64.0)

------------------------------------------------------
Non-current liabilities
Corporate bonds 20 (838.2) *
Provisions 22 (9.4)
Other financial liabilities 19 (11.8)
Other liabilities 18 (214.4)
------------------------------------------------------

So what liabilities should I include as "interest-bearing" and therefore as debt?

Bank loans+overdrafts note 17 repayable on demand and bear interest
Trade payable+other liabilities note 18 do not bear interest and are generally settled on 30 day terms. Other creditors and accruals do
not bear interest.

Other financial liabilities note 19. Seem to mainly be forexs+share purchase contracts. I see no mention of a rate, so I'm assuming non interest bearing.
Corporate bonds note 20. These are interest bearing (there is a confusing sub-note 20, referring to derivatives used to manage IR risk, which next then state a nominal value of 787.6, presumably of their bond-related after the hedging, but for simplicities sake, I'll stick with 838.2 as value of this debt)
Dividends note 8. Non interest bearing.
Provisions note 22. Non interest bearing.

I'm going to assume that the gross (interest-bearing) debt for NXT at y/e of 2015 is overdrafts/bank loans 2.8 + corporate bonds 838.2 = 841.0.

So using debt ratio

gross debt/total assets = 841/2282.3 = 36.84%.

Would anyone be able to verify that my thought process is correct? That is, going by the commonly held definition of "debt ratio" (gross debt/total assets), that for NXT 2015 my calculation is correct.

Many thanks
Matt (and Mel)

Melanie
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Re: Learning about capital-based debt measurement techniques

#145673

Postby Melanie » June 14th, 2018, 8:32 pm

Sorry I forgot to include a link to the AR if anyone is interested.
http://www.nextplc.co.uk/~/media/Files/ ... al-web.pdf
The consolidate balance sheet is on page 82.

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Re: Learning about capital-based debt measurement techniques

#146105

Postby Itsallaguess » June 16th, 2018, 2:46 pm

Melanie wrote:
So using debt ratio

gross debt/total assets = 841/2282.3 = 36.84%.

Would anyone be able to verify that my thought process is correct? That is, going by the commonly held definition of "debt ratio" (gross debt/total assets), that for NXT 2015 my calculation is correct.


I won't comment on it being correct or not, but isn't a snapshot in time for this sort of ratio just part of the story?

What I mean by that is to perhaps ask how the debt ratio changes over a number of reporting periods for a given company, and how those ratios might compare to other companies in the same sector.

For example, if a company has just made a large acquisition, but where integration and pay-back might take a relatively short amount of time, then a high debt-ratio at a single point in time might look worse than the longer-term outlook, and perhaps taking a wider view over a number of periods might show that debt-ratio improving quite rapidly to a more acceptable level.

A similar 'single-snapshot debt-ratio' for a different company, but with the same figure for a single point in time, might, if we look at the wider periods for the company, show that the debt-ratio is perhaps getting worse over a number of periods.

For both of the above companies, the single-snapshot ratio might be the same, and might put an investor off if they only see the single snapshot, but where a wider, multi-period view is taken (and a better understanding is developed as to why a level of debt might have accrued), an investor might then see that for the first company which has perhaps expanded and will benefit over the medium term from such an expansion, it might actually look to be a good prospect for investment, and perhaps then an investor might only be put off the other company to any large degree, given this wider view.

Some other debt-analysis options here if it's of any interest - https://www.finstanon.com/articles/37-l ... o-analysis

Cheers,

Itsallaguess

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Re: Learning about capital-based debt measurement techniques

#146138

Postby Melanie » June 16th, 2018, 5:12 pm

Thanks Itsallaguess,

I agree that looking at average debt over a longer period is worthy of consideration...

I do think I could benefit by firstly figuring it out over just a single period mind you!

Matt

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Re: Learning about capital-based debt measurement techniques

#146150

Postby Melanie » June 16th, 2018, 6:16 pm

I'm still struggling with finding some debt measurement parameters, in which I can then compare against a recommendation.

The parameter I'm trying understand right now is called "debt ratio". Phil Oakley's book (indeed I followed it through myself for his Domino example) has me to believe that for the debt figure (i.e. the numerator), we should take a subset of the datas from both of the liabilities section, that being the figures which accrue interest. He then divides this "debt value" by Total Assets...and then recommends a magic figure of 0.5 (50%)...i.e. should the ratio you derive be lower this value, then (in general, yes, I appreciate that some sectors differ against others) the firm could well be a good prospect. But Phil Oakley suggesting avoiding firms whose ratio is greater that this.

So I calculating this value initially in this thread for NXT (2014-15) getting

DEBT  = 838.2 + 2.8 = 841 (I used banks loans+bond payouts)
TOTAL ASSETS = 2,282.3

Giving 36.84%.

I repeated the calculation for NXT 2017-18, in order to compare to some publicly available data.

DEBT  = 908.5 + 180 = 1088.5 (I used banks loans+bond payouts)
TOTAL ASSETS = 2561.5

Giving 46.15%.

This is great - yes both figures less that 50%. Then I search online e.g. https://shares.telegraph.co.uk/fundamentals/?epic=NXT . But I cannot find any figures remotely like mine. I see, amongst others,

Gross Gearing (%) 81.16
Debt Ratio 70.69

After playing with a few figures from the AR I realised that Gross Gearing 81.16 is probably "Total Liabilities"/"Total Assets". (2078.9/2561.5=81.16). And indeed from

https://www.myaccountingcourse.com/fina ... debt-ratio

From the above website we see "Total Liabilities"/"Total Assets" being used as the formula for "debt ratio", and further 0.5 being stated to be the magic figure.

A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities.

But this is crazy, Phil Oakley's formula takes a subset of the liabilities sections, whereas the above website I have linked, uses the total liabilities value for the debt (numerator) but the same value as the denominator, yielding two quite different answers. However 0.5 is being recommended as the reference value for both!

So I'm now very puzzled....In order to derive a figure which I should compare (with further research + consideration) to 0.5, using

debt / total assets

Should I take debt to be all total liabilities, or only those liabilities which accrue interest?

Any help would be appreciated,
Matt and Mel

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Re: Learning about capital-based debt measurement techniques

#146358

Postby Gengulphus » June 17th, 2018, 6:08 pm

People have come up with endless ways of calculating potentially-interesting financial ratios, and there's only a limited number of good short terms available to describe them, so it's not surprising that sometimes (actually quite often!) different people use the same short term for quite different things. And the same goes for websites, newspapers, etc - so don't be surprised if you find different figures based on different calculations depending on which data source you're using!

One thing to also bear in mind with free data sources in particular is that actually getting the data is not free for the provider. While actually calculating the ratios they supply from the raw company data obtained from company reports and market data such as share prices is very cheap once they've got their computer systems set up to do the calculations automatically, they have to either pay employees to obtain the underlying data from company reports, etc, and input it, or to pay another company to supply it. In the latter case, that company has the same choice, and so on: ultimately, there is always the cost of paying somebody to obtain it from company reports and input it, and will be until and unless the content of company reports becomes sufficiently prescribed that it can be automatically extracted (which is unlikely to happen any time in the foreseeable future IMHO: requiring a tiny AIM company to adhere to the same format as (for instance) an insurance giant seems pretty unrealistic!).

The point of that is that data that comes only from the main financial statements in a very straightforward way will be considerably cheaper to obtain and input than more detailed stuff that comes from looking at the exact meaning of descriptions of particular items or (still worse) looking up notes to the financial statements, simply because collecting it requires much less human time, and the human time it does require is considerably cheaper per hour because a lot less expertise is needed. And for a data provider dealing with thousands of company report per year, that's quite significant!

I think the matter of "debt" vs "liabilities" is a particular case of that. Data about "liabilities" is very easily obtained from balance sheets, as the word is part of two of the very standardised sections of a balance sheet (i.e. current and non-current liabilities). If it's liabilities you want to know about, there really is very little point is talking about "debt" instead from an investment point of view - why use up two of the limited supply of good short terms for the same thing when the use of one of them is that standardised? But nevertheless, some data providers call liabilities "debt" - an example is ADVFN whose company "Financials" pages (e.g. https://uk.advfn.com/p.php?pid=financia ... xt&s_ok=OK, which is the one for Next) have lots of ratios involving the word "debt" or "gearing", while the only mention of "liabilities" is as a section heading in the table of balance sheet information. But if one actually looks at the calculations of those ratios (which are helpfully but not all that obviously explained by making each ratio name a link to an explanation of how it's calculated), one finds explanations such as:

Gross Gearing ratio, is the Total Debt (short-term and long-term) as a percentage of the Total of Shareholders' funds and Debt funds. The calculation is the following:

= [(creditors,short + creditors,long + creditors,other + subordinated loans + insurance funds) / (ord cap,reserves + prefs,minorities + creditors,short + creditors,long + creditors,other + subordinated loans + insurance funds)] * 100

= [TOTAL LIABILITIES / TOTAL ASSETS] * 100

where the actual formulae don't mention "debt" at all! The only reason I can see for doing it that way is a combination of wanting to use relatively cheap data, to provide "debt" and "gearing" figures because they're figures investors generally want to use, and not to attract too many user complaints either by making it too obvious that they're using a liabilities/capital type of calculation for gearing rather than a debt/capital sort of calculation or by completely failing to say how they calculate the ratio.

I learnt about that particular example when I used ADVFN many years ago for a quick reminder about some figures for ARM Holdings - not about its debt or gearing, as I could easily remember having previously seen that it had a lot of cash and no debt whatsoever (I don't think it ever did have any debt during its 1998-2016 stockmarket history, though I'm not 100% certain about that). But I happened to notice in passing that ADVFN gave it quite significant "Net Debt" and "Gross Gearing" figures, thought "What the heck!?!" and investigated... It turned out that all the liabilities that ADVFN described as "debt" were things like trade creditors and tax liabilities, and the company was no more in debt than I am because I'm liable to make a payment on account for my 2017/18 tax bill at the end of July and a payment of the rest of it by the end of January next year...

Anyway, the basic points I want to make are:

* I don't recommend using "debt" as a synonym for "liabilities". At least for the individual investor, it simply reduces the ease of distinguishing interest-bearing liabilities from the others, for no real benefit.

* Don't be surprised by different people, websites, etc, using different formulae for the same investment term, and some may be less helpful than others to investors - there are reasonably easy-to-understand reasons why that happens.

* So when you encounter such a difference, the way to resolve it is generally not to ask which is correct, but to decide which you find more informative / useful / helpful for your investment decisions and use that. (So for instance, I haven't used the ADVFN "Financials" pages for debt / gearing information since discovering the above, as I regard a company getting rid of its interest-bearing debts as a good thing, with the only questionable point being whether it could have done something better with the resources, but a company getting rid of its trade creditors as a bad thing, as that would indicate that its business was disappearing...)

Gengulphus

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Re: Learning about capital-based debt measurement techniques

#146376

Postby Melanie » June 17th, 2018, 8:24 pm

Gengulphus wrote:People have come up with endless ways of calculating potentially-interesting financial ratios, and there's only a limited number of good short terms available to describe them, so it's not surprising that sometimes (actually quite often!) different people use the same short term for quite different things.

For sure. That's the case in many disciplines. I'm involved in those of engineering and computing. When we say "code", we might mean high level language which is almost readable to the lay person, or we may mean the form only coherent to the processor's computational hardware. Of course the meaning is usually clarified by the current context...

Gengulphus wrote:One thing to also bear in mind with free data sources in particular is that actually getting the data is not free for the provider. While actually calculating the ratios they supply from the raw company data obtained from company reports and market data such as share prices is very cheap once they've got their computer systems set up to do the calculations automatically, they have to either pay employees to obtain the underlying data from company reports, etc, and input it, or to pay another company to supply it. In the latter case, that company has the same choice, and so on: ultimately, there is always the cost of paying somebody to obtain it from company reports and input it, and will be until and unless the content of company reports becomes sufficiently prescribed that it can be automatically extracted (which is unlikely to happen any time in the foreseeable future IMHO: requiring a tiny AIM company to adhere to the same format as (for instance) an insurance giant seems pretty unrealistic!).

Of course. Nothing is ever free. And as far as I'm concerned if it is, it's usually "too good to be true". This is why Mel and I are happy to do the research and the number crunching ourselves.

And yes after looking at smaller caps (e.g. TUNE and AMS) and then larger ones (e.g. PSN and NXT), we are finding not only format/presentation differences, but also content differences, i.e. some firms will have no concept of some of the entities others may find themselves reporting. E.g. an online estate agent I imagine won't need to report lease costs, but a high street retailer does; some firms employ bond issues/loans to fund themselves from day 1, whereas others started out on the personal savings of several rich founders.

Gengulphus wrote:I think the matter of "debt" vs "liabilities" is a particular case of that. Data about "liabilities" is very easily obtained from balance sheets, as the word is part of two of the very standardised sections of a balance sheet (i.e. current and non-current liabilities). If it's liabilities you want to know about, there really is very little point is talking about "debt" instead from an investment point of view - why use up two of the limited supply of good short terms for the same thing when the use of one of them is that standardised? But nevertheless, some data providers call liabilities "debt" - an example is ADVFN whose company "Financials" pages (e.g. https://uk.advfn.com/p.php?pid=financia ... xt&s_ok=OK, which is the one for Next) have lots of ratios involving the word "debt" or "gearing", while the only mention of "liabilities" is as a section heading in the table of balance sheet information. But if one actually looks at the calculations of those ratios (which are helpfully but not all that obviously explained by making each ratio name a link to an explanation of how it's calculated), one finds explanations such as:

Yes I understand. You helped me figure that out in an earlier thread viewtopic.php?p=143344#p143344. To be honest, it wasn't really this that I was fishing for with my last post viewtopic.php?p=146150#p146150 on this topic.

My point is this, yes, there are lots of ratios for company assessment. And yes, rather than being spoonfed by a subscription-based investment advice service Mel and I would like to manage these ratios ourselves. However:

1. We want to minimise the set of ratios/parameters to calculate
2. Most importantly the ratios themselves, are meaningless without the appropriate grading system, i.e. "over 40 is bad", "over 1.5 is ok, but 2 and above is excellent" etc. I.e. the context in which to make the calculations useful.

And that brings me to the crux of my point.

Looking at Phil Oakley's definition of the "debt ratio"; he clearly extracts only the liabilities which seem to accrue interest (i.e. debt proper) (see viewtopic.php?p=146150#p146150 I have put an asterisk against those) and then divides by all the assets and derives a value, which he then states should be less than 0.5 or 50%. That, is what is fundamental, i.e. the fact not only do we have a ratio, but that we have a reference (i.e. 0.5) which we can score that against.

And that was why I was puzzled by seeing a different ratio (albeit using the same name!), but different nonetheless, i.e.

total liabilities / total assets

(The difference being the numerator will be larger, possibly a lot larger, since it carries all the "liabilities"), but however the website in question https://www.myaccountingcourse.com/fina ... debt-ratio still recommends that 0.5 is the magic reference value!

So whilst I appreciate that a lot of you have been at this game for a long while now, and can make assessments faster and with less adherance to hard and fast guidelines, for myself and Mel, we'd like to be able to prevent ourselves investing in Carillion (wherever possible!), by at a cursory indebtness evaluation.

In summary, what is useful for us:

(total of just the interest bearing liabilities / total assets) < X

and/or

(total of all liabilities on the Balance sheet / total assets) < Y

Obviously we do not expect a perfect "it will never go wrong, if it's this" type recommendation! Just a ballpark figure, like I think you may have mentioned re. interest cover in that earlier thread. Of course if you don't use a ratio like this for your personal capital-based debt assessments, then which ones, if any, do you use?

thanks
Matt and Mel

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Re: Learning about capital-based debt measurement techniques

#146397

Postby Gengulphus » June 18th, 2018, 7:58 am

Melanie wrote:In summary, what is useful for us:

(total of just the interest bearing liabilities / total assets) < X

and/or

(total of all liabilities on the Balance sheet / total assets) < Y

Obviously we do not expect a perfect "it will never go wrong, if it's this" type recommendation! Just a ballpark figure, like I think you may have mentioned re. interest cover in that earlier thread. Of course if you don't use a ratio like this for your personal capital-based debt assessments, then which ones, if any, do you use?

I aim to use:

(net debt)/(net assets, excluding goodwill)

where "net debt" means interest-bearing liabilities minus interest-bearing assets that can be reliably realised at short notice (say at most about a month).

I say "aim" because I don't always try to work it out exactly. E.g. I search for a company-supplied "net debt" (or "net borrowings") figure; if I find it, I'll do a quick skim through how their calculation of the figure for sanity-checking purposes, and as long as they do give that calculation and I don't find anything that is a significant part of it and seems clearly wrong to me, I'll accept the figure without investigating more deeply. Similarly, I'll generally accept the company's "cash & equivalents" figure for the interest-bearing assets that can be reliably realised at short notice, and some companies don't give a breakdown of intangible assets (in which case I'll probably exclude all of them to err on the safe side).

I also haven't put "< Z" at the end of that because that would suggest that I use a simple threshold on the result, which I don't. I'll basically just use it as input to a judgement call about the company's debt situation. Other factors include the interest position, when the debts are repayable and under what conditions they might become repayable early, how reliably the company's assets can be converted to cash if necessary (e.g. property is much more reliably sellable for a decent price than old, specialised machinery), the nature of the company's business (e.g. utilities have pretty reliable cash flows, banks can only operate profitably by having huge amounts of debt), etc.

Gengulphus

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Re: Learning about capital-based debt measurement techniques

#146434

Postby Melanie » June 18th, 2018, 12:30 pm

Gengulphus wrote:I aim to use:

(net debt)/(net assets, excluding goodwill)

where "net debt" means interest-bearing liabilities minus interest-bearing assets that can be reliably realised at short notice (say at most about a month).

I say "aim" because I don't always try to work it out exactly. E.g. I search for a company-supplied "net debt" (or "net borrowings") figure; if I find it, I'll do a quick skim through how their calculation of the figure for sanity-checking purposes, and as long as they do give that calculation and I don't find anything that is a significant part of it and seems clearly wrong to me, I'll accept the figure without investigating more deeply.

Ok I understand. I was confused at first because previously https://lemonfool.co.uk/viewtopic.php?p=142636#p142636 you used what at first glance would appear to be a different definition for net debt.

i.e.
Gengulphus wrote:its net debt (i.e. its gross debt with cash & equivalents netted off)


But I see that you actually equate a firms cash holding with interest-bearing asset.

Gengulphus wrote:Similarly, I'll generally accept the company's "cash & equivalents" figure for the interest-bearing assets that can be reliably realised at short notice

Why do you say these are interest bearing? Is it under the assumption, that they will be in a bank account where interest is paid?

Gengulphus wrote:I also haven't put "< Z" at the end of that because that would suggest that I use a simple threshold on the result, which I don't.

Yes, I appreciate that. I just used the simple inequality to get a debate going. In our spreadsheet we are aiming to use red for "this is probably bad", green "probably good", and "amber" meaning it needs further investigation.

However......what, figures of Z do you think are useful as indicators of either definitely good or definitely bad, for one or two classes of firms, with all things being equal?

thanks Matt

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Re: Learning about capital-based debt measurement techniques

#146484

Postby Gengulphus » June 18th, 2018, 5:37 pm

Melanie wrote:
Gengulphus wrote:Similarly, I'll generally accept the company's "cash & equivalents" figure for the interest-bearing assets that can be reliably realised at short notice

Why do you say these are interest bearing? Is it under the assumption, that they will be in a bank account where interest is paid?

On the assumption that the company's CFO is making certain that the company is getting the best available interest rate on the firm's cash, subject to the cash being sufficiently safe and available at sufficiently short notice for the company's needs. If that isn't happening, he or she is neglecting a rather basic part of the job!

Also, I should say that there's a certain amount of common sense needed about things being "interest-bearing". If for instance the company has some of its cash in a bank account with a variable interest rate, and that rate drops to 0.00%, I don't want to suddenly reclassify it as not reducing net debt: that could cause the result of my net debt calculation to increase noticeably for an event whose effects on the company are probably very minor. Likewise in reverse for it rising above 0.00%... Far better to reckon it's interest-bearing all along (especially as I almost certainly have realistic way of determining which of the company's bank accounts are on 0.00% interest and how much is in them), and the applicable interest rate just happens to temporarily be zero.

There can be similar common-sense considerations about interest-free loans, though on a consolidated basis they're pretty rare, especially for reasonably big companies.

Melanie wrote:
Gengulphus wrote:I also haven't put "< Z" at the end of that because that would suggest that I use a simple threshold on the result, which I don't.

Yes, I appreciate that. I just used the simple inequality to get a debate going. In our spreadsheet we are aiming to use red for "this is probably bad", green "probably good", and "amber" meaning it needs further investigation.

However......what, figures of Z do you think are useful as indicators of either definitely good or definitely bad, for one or two classes of firms, with all things being equal?

Well, 0% or less (as a result of having net cash, not negative equity!) is definitely good. At least as regards what it says about the company not getting into debt trouble, of course - it might well indicate that the company is using its assets rather inefficiently, but that's a matter for other ratios such as ROCE.

And while negative equity (i.e. a negative divisor in the calculation of the ratio) is not definitely bad, it is definitely a reason to investigate the company's debt situation in much more detail!

Beyond that, sorry, but I'm going to pass on that question, at least for the moment. I've contemplated a few answers, but they're all IMHO either too misleading about what I do or too rambling... I might come back on it sometime, but no promises!

Gengulphus

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Re: Learning about capital-based debt measurement techniques

#146514

Postby Melanie » June 18th, 2018, 7:41 pm

Gengulphus wrote:On the assumption that the company's CFO is making certain that the company is getting the best available interest rate on the firm's cash, subject to the cash being sufficiently safe and available at sufficiently short notice for the company's needs. If that isn't happening, he or she is neglecting a rather basic part of the job!

Sure. Have to say that for an individual saver short-notice and good IR are mutually exclusive! My Ford Money flexible saver acc. is 1.22%, and I'll get the money transferred to my current account within 24 hours.

Gengulphus wrote:Well, 0% or less (as a result of having net cash, not negative equity!) is definitely good.

Yes, of course. Again that's not really what we are after. What Mel and I are wanting, is to avoid buying into a firm such as Carillion, which runs into big problems as a result of a big debt burden. We appreciate that there are no crystal balls being handed round, and that everything has an associated risk etc. etc. So as far as we are concerned an overall surplus is great from this perspective.....but we appreciate that a lot of functional firms do have appreciable debt (which is often put to good use), e.g. Next one of my recent studies, certainly has some and it seems to be fairly vibrant at this time, and so too does Unilever....in fact we've have heard that ULVR's debt is not that good, since from what I read, there are rumours this was taken on to keep takeovers at bay.

I guess in our minds, debt is fine, when the going is good. But when tough times hit , obviously firms will struggle to service it. Lots of commentators are warning about lots of LBOs in the States....so presumably they are ticking bombs waiting for the next crisis. Similarly, didn't large debts from similarly funded takeovers send "Dignity" to it's grave, pardoning the pun?

So our hopes are to at least stand a chance of being able to apply some analysis to accounts, to sort out the various NXT, ULVR, CLLN, DTYs etc.

Gengulphus wrote:And while negative equity (i.e. a negative divisor in the calculation of the ratio) is not definitely bad, it is definitely a reason to investigate the company's debt situation in much more detail!

How is negative equity even possible? Surely that would imply that shares in the firm have to be given away? I don't understand.

Gengulphus wrote:Beyond that, sorry, but I'm going to pass on that question, at least for the moment. I've contemplated a few answers, but they're all IMHO either too misleading about what I do or too rambling... I might come back on it sometime, but no promises!

No sweat, Geng. As usual many thanks for your time and patience.

Matt and Mel

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Re: Learning about capital-based debt measurement techniques

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Postby Gengulphus » June 19th, 2018, 10:32 am

Melanie wrote:
Gengulphus wrote:And while negative equity (i.e. a negative divisor in the calculation of the ratio) is not definitely bad, it is definitely a reason to investigate the company's debt situation in much more detail!

How is negative equity even possible? Surely that would imply that shares in the firm have to be given away? I don't understand.

It's very easily possible, and no, it doesn't mean the shares have to be given away! That's basically because the liquidation value of a company (i.e. its value if its business operations were shut down, its assets sold off and its liabilities paid off) is generally less than its value as a going concern, often much less. In addition, the equity value of a company on its balance sheet is only an approximation of its liquidation value (as we've previously discussed, the book value of assets is often significantly different from what they can be sold for) and its market capitalisation has to only be an approximation of its value as a going concern (at least, I find it inconceivable that the value as a going concern varies as rapidly and greatly as its share price and market capitalisation do!), and both of those approximations are pretty poor ones. Put those together, and the conclusion is pretty clear: there's very little relationship between the market capitalisation of a company and the equity value one gets from its balance sheet, or equivalently after dividing both by its number of shares in issue, between its share price and its equity value per share.

And it really does happen in practice, especially if one excludes intangible assets from the capital-value measure one uses. For example, British American Tobacco's 2017 balance sheet shows equity of £61,026m, but intangible assets of £117,785m, so its net tangible asset value comes out as -£56,759m and any ratio involving dividing by that capital-value measure should be considered to be a special "negative equity" value, not a numerical value. Consulting the note referenced by the "Intangible assets" line shows that the biggest part of those intangible assets is trademarks with a book value of £73,120m and goodwill at £44,147m is only the second largest part (a couple of much smaller categories make up the rest), so my preferred "net asset value excluding goodwill" capital-value measure is positive at £16,879m and that doesn't apply to it, but "negative equity" results do happen sometimes for it - an example is Imperial Brands' 2017 annual report, whose balance sheet shows £6,226m equity and £19,763m intangible assets, with a note showing that £12,265m of them are goodwill. They even occasionally happen if one uses net asset value with no exclusions, though that's rare enough that I can't remember any specific example offhand.

Gengulphus

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Re: Learning about capital-based debt measurement techniques

#146646

Postby Melanie » June 19th, 2018, 12:18 pm

Gengulphus wrote:It's very easily possible, and no, it doesn't mean the shares have to be given away! That's basically because the liquidation value of a company (i.e. its value if its business operations were shut down, its assets sold off and its liabilities paid off) is generally less than its value as a going concern, often much less.

Ok, yes, of course the fundamental equation of accounting.

net assets = total assets - total liabilities;  net assets = total equity

Apologies. I'm skill getting to grips with this!

FWIW, I'm going spend a few days reading my new book
https://www.amazon.co.uk/Accounts-Demys ... 1292084847

and then get back into this at some stage. I'm planning on taking a few debt parameters from NXT and ULVR and try to compare what the figures are telling us about the debt positions of those firms.

Matt and Mel


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