A company with too much debt is like a tall vase with a narrow base. Everything looks fine until you kick the table, at which point it falls over and explodes into thousands of pieces.
In an attempt to avoid companies that might explode, I always look for those with “prudent” amounts of debt. At the same time, I try not to be so restrictive that I can’t find anything to invest in.
Avoiding companies with too much debt
Over the years, I’ve defined “prudent” in several different ways, but my current rules of thumb for interest-bearing debts are:
- Only invest in a defensive sector company if its Debt Ratio is less than 5
- Only invest in a cyclical sector company if its Debt Ratio is less than 4 (doesn’t apply to banks)
The Debt Ratio, for reference, is the ratio between the company’s current total borrowings and its 5-year average post-tax profit (preferably normalised or adjusted profits).
There is no magic to this; it’s just an approach which I’ve found to be reasonably good at differentiating between companies that are going to run into trouble because of their debts, and those that aren’t (I think I first read it in “Buffettology”, a book I highly recommend).
Another financial obligation I’ve kept an eye on for the last few years is defined benefit pension schemes. Many companies don’t have one, but if a company does have one then in most cases (possibly all) it is legally obliged to ensure the pension scheme is well funded.
If the pension scheme’s assets do not cover its long-term liabilities, the scheme will have a pension deficit and the company will have a legal obligation to close that deficit at some point. That will often mean shovelling cash into the fund, which means less cash for dividends or other things that create shareholder value.
Avoiding companies with excessively large pension obligations
I have a rule of thumb for pension obligations as well, just because I like to systemise my decision-making as much as possible. The rule is:
- Only invest in a company if its Pension Ratio is less than 10
The Pension Ratio is more or less the same as the Debt Ratio, only this time the company’s total defined benefit pension obligations are compared to its 5-year average post-tax profit.
So far I’ve always looked at the Debt and Pension Ratios separately; I guess because I never thought about joining the dots,…
