10. Strong Financial Position

Cash flow per share is only one measure of a company’s financial strength. The level of gearing, cash balances and general liquidity are also very important indicators of its capacity to survive in difficult times.

The gearing ratio

The gearing ratio is the accepted short-hand way of indicating the extent of a company’s borrowings. Net gearing is calculated by taking overall borrowings, deducting cash, treasury bills and certificates of deposit and then expressing the resultant figure as a percentage of shareholders’ funds, including intangibles such as brand names, patents, copyrights and goodwill. Note that marketable securities are not deducted from borrowings as they may not be realisable in an emergency. Gross gearing is simply the overall borrowings of a company, without any deductions for cash and equivalents, expressed as a percentage of shareholders’ funds.

REFS shows both net and gross gearing, both including and excluding intangibles , and indicates whether or not borrowings are repayable in under one year, under five years or, by implication, over five years. As you can see from the typical panels below, Scottish & Newcastle had net gearing of 39.5%, whereas Next had net gearing of -47.5% (48.8% cash less gross gearing of 1.36%). Expressed another way, Next’s net cash per share (also shown in REFS) was 45.5p against the June 1996 share price of 564p:

For general guidance, gearing of over 50% might be a cause for concern, especially if a large proportion of a company’s borrowings are short-term. A highly geared company is much more likely to be fully invested and committed operationally, so it is far more vulnerable than an ungeared one. In particular:

1. Any company with high gearing, which includes bank and other short-term borrowings, is likely to be very sensitive to changes in interest rates.
2. A highly geared company can be very vulnerable, and can fail completely, during a liquidity crisis, especially if most of its borrowings are short-term. There is no substitute for cash in the bank when a gale is blowing through world financial markets.
3. The results of highly geared companies tend to exaggerate the underlying trend. All shareholders’ funds are invested, and further substantial borrowings result in the company being fully committed and therefore subject to prevailing winds. When businesses are recovering, high gearing can be a massive advantage for shareholders but the reverse is also the case in tougher times.
4. A highly geared company is obviously less well equipped to deal with the unexpected, such as a major strike or a sudden recession.

As with other financial statistics, sector comparisons are of particular interest. The kinds of companies that tend to own their properties are, for example, likely to be more highly geared than those which do not require large premises or prefer to rent accommodation.

The table above shows the 25 FT-SE Mid-250 companies with the highest net gearing on 1 April 1996. As you can see Eurotunnel led the field with horrific gearing of 458%. There are arguments for showing gearing as a percentage of market capitalisation to eliminate anomalies, especially as nowadays so many companies have very substantial intangible assets which are not in their balance sheets. However, I prefer to use the harsher measure of comparing gearing with shareholders’ funds and to check it against market value if the figure appears to be absurd.

In The Zulu Principle I suggested that if the gearing of a company was over 50% of net assets, it should be avoided as an investment.

Nowadays, I am much more tolerant of high gearing provided cash flow is really strong and gearing is being brought down rapidly. Gearing is a trading indicator that is always based on last year’s accounts. If the current year is progressing well and a substantial cash flow is being generated, this should be borne in mind. For example, in early 1995, the shares of Frank Usher Holdings plc were about 130p and gearing was 76% based on the figures in the annual report for the financial year ending 31 May 1994. However, cash flow in 1994 was over 16p per share with only 1p of capital expenditure. 1995 profits were forecast to be higher, so it looked as if cash flow would soon reduce gearing to a more tolerable level and the company’s brokers, Credit Lyonnais Laing, forecast that gearing would be only 10% by 1997. In the event, by 31 May 1995, gearing had already been reduced to about 20%. Clearly therefore, Usher’s gearing in 1994 was not a problem even though the stark figure of 76% was rather offputting at first sight.

Four investment tools

There are four other investment tools that I have found helpful in measuring a company’s financial strength:

1. The quick ratio is an attempt to see what would happen if a company suddenly had to pay off all of its current liabilities. For this reason, only assets that can be readily turned into cash are included and stock and work in progress is excluded.

The basic formula is therefore:

Generally speaking, I like to see a quick ratio of over one, but many retailing operations can manage on much less, as they can sell their products several weeks before paying their suppliers. Because of the very different circumstances of different businesses, the quick ratio of a company is best compared with the sector averages and very similar companies within the sector.

It is important to check the quick ratio of a company when its annual report is published. If it is low in comparison with other members of the company’s peer group and it is deteriorating, this can be a prelude to a fund-raising exercise.

2. The current ratio is similar to the quick ratio and shows the number of times current liabilities are covered by current assets. It is determined by dividing the current assets of a business (including stock and work in progress this time) by its current liabilities.

The basic formula is simply:

A ratio of 2.00 or more is usually a sign of financial strength. A low ratio of under 1.25 (1.00 for retailers) can be a sign of weakness.

Also, any major fluctuations in its current ratio can alert investors to fundamental changes in a business’s financial structure. Retailing companies usually have small debtors, as most of their sales are paid for in cash; they therefore usually have lower than average current ratios. In other industries, high current ratios can sometimes result from excessive stocks or poor control of debtors.

3. Interest cover shows the company’s capacity to continue paying interest on its borrowings out of annual profits. It is calculated by taking a company’s normalised historic profits before interest and taxation and dividing them by the annual interest charge.

This is the basic formula:

Low and/or deteriorating interest cover is an obvious danger signal and can sometimes be a precursor to a reconstruction, fund-raising or business failure.

The REFS gearing table also highlights interest cover. As you can see, Eurotunnel appeared to be in a parlous state with its interest charges only 50% covered. In contrast, EMAP’s interest charges were covered a healthy 7.7 times and Securicor’s and Inspec Group’s cover was into double digits.

4. Dividend cover shows the extent to which the historic dividend is covered by the company’s earnings, ignoring the possible ACT consequences of a full distribution. It is calculated by taking a company’s normalised historic earnings (or earnings per share) and dividing them by the net dividends payable (or net dividends per share), as follows:

or

It is obviously comforting if a company’s dividend is two to three times covered. However, dividend cover comes more into its own as an investment measure when the cover is very slender. In that event, there may be a cut in dividend, with disastrous consequences for the share price.

It is interesting to note that great growth companies like Rentokil, Reuters, Perpetual, Next, Eurotherm, Logica, Admiral, Parity, Druck and Halma seem to generate plenty of cash. Perhaps for this reason high gearing makes me feel ill at ease. I like companies that spit out cash regularly and preferably become awash with it. As it is possible to invest in companies which satisfy my general investment criteria and have strong cash flow and strong balance sheets into the bargain, it seems unnecessary to take an extra risk unless circumstances are very special indeed.

Summary

1. Gearing of more than 50% can be a cause for concern. However, compromises can be made if cash flow is really strong and gearing is being brought down rapidly.

2. The quick ratio shows how well assets, that can be readily turned into cash, cover current liabilities. It is therefore calculated by taking current assets less stock and work in progress and dividing the result by current liabilities. Generally speaking, look for a quick ratio of more than one, but bear in mind that many retailers can operate on much less.

3. The current ratio is similar to the quick ratio but includes stock and work in progress. It will therefore always be higher than the quick ratio. A current ratio of two or more is usually a sign of financial strength.

4. Interest cover is the measure of a company’s capacity to continue paying interest on its borrowings out of annual profits. Low or deteriorating interest cover can be a danger signal.

5. Dividend cover shows the extent to which historic dividend is covered, ignoring the possible ACT consequences of a full distribution.

6. Great growth companies spit out cash and usually seem to have plenty of it. As it is possible to find shares which satisfy all the growth criteria and have strong balance sheets, there is no need to take the extra risk of investing in companies with very high indebtedness, poor cash flow and weak balance sheets.