Corporate debt is at an all-time high, and this is usually a bad sign. Those who invest in this debt are usually not good at predicting crashes – because they are too invested in the boom side of the business cycle.
In a recent article Mike DiBiase, editor at Stansberry’s Credit Opportunities, provides some guidance on how to look at companies and debt from a purely crisis point of view.
“We only care whether a company can pay our interest and principal,” says DiBiase. “That’s all that matters when investing in bonds. We analyse two factors to determine if a company can do that…
- Whether the company can afford the annual interest costs on all of its debt, and
- Whether it will have enough cash on hand to pay off our bond at maturity.”
The first factor is the most important. If the company can’t afford to pay the interest on all of its debt (not just its bonds), its lenders can force the company into bankruptcy. One should never invest in a bond from a company that is likely to go bankrupt before the bond matures.
To address the first factor, it’s important to look at the company’s “interest-coverage ratio.” This means the number of times the company’s “cash profits” cover its interest costs. Cash profits are the cash that a company produces from its core operations. The metric can be found in the statement of cash flows under the “net cash provided by operating activities” line.
The formula most analysts use to measure interest coverage is accounting earnings before interest and taxes (“EBIT”) divided by interest expenses. DiBiase recommends using cash profits before interest instead.
Unlike accounting earnings, cash profits can’t be faked. That’s because cash profits don’t include any estimates that management can easily manipulate. You can’t fake cash.
On this basis, a good company should have at least two times interest-coverage.
That tells us the company can safely afford its interest payments, with enough cushion to absorb unforeseen downturns in its business. In addition to telling us whether the company can afford its interest payments, this ratio also gives us a gauge as to how difficult it will be for the company to refinance its debt. Banks want to make sure they will get paid their interest, too. The lower the ratio, the more difficult it will be.
By addressing the second factor, we can figure out whether the company will pay the bond principal when it’s due. If you project that the company won’t have enough cash in the bank at maturity to pay the bond, you know it will need to refinance its debt with other loans to pay bond holders. If that’s the case, look for companies that should have no trouble finding financing when the time comes.
Don’t care how you get paid, as long as the company is able to pay.
In addition to these two factors, you also want to know the worst-case scenario… what would happen in case of a bankruptcy. So it is a good idea to perform a liquidation analysis for every bond.
You must assume the company is forced to shut down its business at some point in the future and sell off all of its assets. Then make an estimate what these assets would be worth in a forced sale.
Then, allocate the sales proceeds to the company’s lenders. Some lenders – like banks – typically get paid first. Bondholders, along with other unsecured creditors like employees and vendors, typically get paid after all senior and secured creditors are paid.
The good news is unlike stocks, bonds aren’t worthless in a bankruptcy. On average, bondholders have historically recovered about $0.40 on the dollar in bankruptcies.
The lesson here is to look at cash rather than accounting earnings.