In my last article, I looked at companies that were recent poor performers in order to identify the characteristics that investors should avoid in the current markets. I concluded that investors would be best served by avoiding highly-priced companies with declining prospects or significant debt, companies not fully funded to cash flow break even, or those involved in the latest market fad. One contributor commented that they expected debt to feature more highly. While this was a factor in the large fall in the share price of XP Power (LON:XPP) , it wasn’t a prominent feature of the other large monthly fallers. This is likely to be due to the small sample size, and I would expect debt to feature in many future fallers. Therefore, I thought it would be worth looking into the topic in more detail.
Gearing
There is a reason that debt in the capital structure of a company is known as leverage or gearing. In the same way that a lever or gear provides mechanical advantage and can multiply the force applied, debt means that the returns to equity are exaggerated. Debt itself is not bad. Indeed, corporate theory suggests that having an amount of debt on the balance sheet is ideal for most companies. The reason is that debt interest is a tax-deductible cost, so companies that hold debt will pay lower taxes.
The problem with debt comes if it is excessive or if future corporate trading is highly uncertain. If a company has not yet reached a sustainably positive operating cash flow position, then having debt on the balance sheet is almost always unsuitable. The reason is that it puts an external time limit on when cash flow profitability needs to be reached. Therefore, new or blue-sky companies should always be fully financed through equity, not debt. As investors know, things rarely go smoothly and within the timeframe an enthusiastic management expects.
Gearing has a specific meaning in finance: a company’s debt-to-equity ratio. Stockopedia actually provides six ratios:
Gross gearing takes the total debt levels, whereas net gearing takes the net debt. Then there are two versions, including and excluding intangible assets. Finally, the third version treats the accounting version of any pension deficit as debt and includes this in the calculation. I wrote more about adjusting for pension deficits here. Which metric investors use…
