The current U.S. economic expansion has hit the 10-year mark. As it continues to age, many equity investors could become increasingly uneasy about the amount of leverage in their portfolios.

It’s a good idea, we believe, for people to regularly review the balance sheets of companies they’re invested in, with a focus on debt—especially during this stage of an expansion. We’ve found that to be most effective, these reviews should delve deeper into a company’s debt than many investors think.

Often, people mistakenly focus their balance sheet review solely on the amount of leverage a company has. But this number alone doesn’t always reveal the firm’s true balance sheet risk. By digging deeper into the balance sheet, investors may uncover risks not evident at first glance. They also may find opportunities that would’ve otherwise been missed.

Why study balance sheets in the first place?

A balance sheet provides essential data for evaluating a company’s financial situation. The information it contains makes it possible to gauge the firm’s ability to manage risks in future hard times and take advantage of potential opportunities over the years to come.

It’s true that many key variables that determine a company’s future success are beyond management’s control. The management team does, however, make important decisions every day on how to spend the company’s capital. These decisions represent one of the few—but important—ways the team can exercise control over a company’s future success.

 

Well-structured, flexible balance sheets in the hands of effective managers—intelligent allocators of capital—increase the potential for companies to withstand difficult times and also be on the offensive when most of their competitors are forced to play defense.

There’s a lot more to the story than the amount of leverage

Because many equity investors assess risk by focusing solely on the amount of debt that a company has, they tend to draw a line in the sand regarding how much leverage they’re willing to tolerate and avoid the investment if it crosses that threshold.

There’s no question that basic calculations commonly used to evaluate leverage can be useful. They often fail, though, to accurately quantify balance sheet risk. That’s because many of them just divide the amount of a company’s debt or interest by the market cap or the earnings before interest, taxes, depreciation, and amortization (EBITDA).

However, late in the economic cycle when market caps and EBITDA often are at peak levels, the results obtained using these simple metrics can become distorted. Surface-level analyses don’t go deep enough in this type of environment. That’s because they don’t assess the sustainability of a company’s cash flows through the full economic cycle. As a result, they don’t address whether or not a company will be able to make its debt payments during challenging times. More importantly, surface-level metrics don’t consider how the company’s balance sheet is constructed.

But how the balance sheet is built can have a dramatic impact on a company’s future solvency and the degree of financial flexibility the firm has to pursue future growth initiatives. This example shows how two balance sheets with the same amount of leverage can present completely different risk and financial flexibility profiles.

 

On the surface, the two companies look very similar financially. They have identical amounts of leverage. But deeper analysis of their respective debts reveals that Company B is in a much better financial situation, with lower risk and higher financial flexibility.

Digging deeper into balance sheet debt: What can investors look for?

Below are four key areas in which we conduct in-depth analysis of a company’s debt. Based on our experience, we believe investors potentially will uncover important information about a company’s true financial situation by taking time to:

  1. Evaluate the amount of debt closely. Besides considering a company’s debt/equity ratio, consider the future cash flows the company will have to generate in order to support its debt. The more sustainable those free cash flows are, the more leverage the company can handle.
  2. Analyze the debt’s maturity profile. Does the firm have significant rollover risk in the near future, or is the debt appropriately termed out over the long run? This is especially important in a rising interest rate environment, where maturing debt will have to be refinanced at relatively higher interest rates.
  3. Study the vehicles being used for the debt. For example, what percentages of the debt are in bank loans, high-yield bonds, convertible bonds, and preferred stock? Each of these carry differing amounts of financial flexibility. What’s the company using as collateral for the debt, and what’s the company’s true cost of capital across all of the debt vehicles being used?
  4. Examine the underlying debt covenants. Are there restrictions that would limit the company’s ability to survive a recession or a crisis without having to raise equity to service the debts or limit flexibility? Many companies have restrictions that force them to go into survival mode as cash flows fall. These restrictions could force the company’s management team to satisfy corporate bondholders at the expense of equity holders—a situation that may be catastrophic for equity investors.

By digging into these areas of a balance sheet, investors can learn a great deal about a company’s risk profile and financial flexibility—information that may play a key role in helping them decide on the company’s future prospects and its suitability for their portfolio.

 

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