The very nature of finance is that it cannot be profitable unless it is significantly leveraged and as long as there is debt, there can be failure and contagion ~ Alan Greenspan
EXECUTIVE SUMMARY
In finance, profitability often relies on leverage, which means using debt. Debt can lead to failure and contagion. Access to cash, mainly through debt, is essential for growth.
The decision to increase debt and how much to take on is crucial. To determine this, one should:
Prepare projections for the growth or acquisition, considering different scenarios.
Determine Free Cash Flow (FCF) to assess cash needs and debt levels.
Calculate the funding gap for cash flows required, considering a cushion.
Understand the Cash Conversion Cycle to gauge timing and magnitude of cash flow.
Calculate Debt Service Coverage Ratio (DSCR) and Interest Coverage Ratio (ICR) to assess debt repayment capacity.
Model in debt and corresponding interest payments.
Determine the target DSCR and target debt level based on profitability.
The goal is to find the optimal debt level that allows the company to service its debt while generating sufficient profits beyond debt repayment.
INTRODUCTION
Some may argue with Mr. Greenspan’s statement, but one thing is certain; accelerated and exponential growth to capitalize on current and potential demand requires access to cash, and lots of it. Unless, there is an unlimited availability of cash through equity financing, debt financing is the next most efficient financing option.
Using 2008 as a baseline, it is apparent that the corporate debt market has increased significantly and as interest rates increase, the prospect of cheap debt fades. Companies are faced with the decision of taking on debt to grow and expand their business or risk becoming irrelevant. How does one make the decision to increase leverage? How does one go about making decisions to determine how much debt is safe to take on; the optimal balancing act?
Given the above, we thought it would be appropriate to concentrate on debt and raise the following question: How Much Debt it too much Debt?
This article follows important considerations in determining the need, capacity and efficacy of debt. In order to make it more relevant we will use an example of an acquisition but the same decision process is applicable to a situations where a Company may need to finance product development or proceed with a major expansion.
Supplement Corp. is considering the acquisition of the Complement Inc. Complement Inc. has approximately $2.5 Million Cash, $8 Million of Inventory, PP&E of $12 Million, Current Liabilities of $2.5 Million, Short Term Debt of $5 Million and Long-Term Debt of $7.5 Million. Acquisition is priced at a 25% premium above net assets which will be paid by using cash of $2.5 Million and will require increasing Long-Term Debt of $5 Million to $12.5 Million. The acquisition will result in increase in sales of 15% and improve gross margins by 5%. In the following steps we follow this example to better illustrate the thought process.
The first table above shows the condensed balance sheets for Supplement, Complement and the Pro forma consolidated balance sheet. The balance sheet for Complement shows the acquisition balance sheet and excludes pre acquisition items. The second table identifies the cost of debt current and post-acquisition and identifies the cost of the acquisition and the funding gap required to close the transaction.
1. Prepare projections for the anticipated decision (growth/acquisition)
It is not uncommon to hear senior executives say “if we only had known”. Projections, by their very nature are just that, “projections”; predictions of future performance based on historical and current information. Despite the inherent limitations with projections, it would be foolish to not perform any projections, as how can one determine cash needs and debt levels, if one does not have a reasonably clear view as to what they anticipate to occur.
Since none of us have a crystal ball, it is important to consider various scenarios to ensure that any decision taken is flexible and can withstand some level of change. Using a Scenario Analysis is one way to accomplish this. It is important to emphasize that projections are a very important part of decision making about debt capacity as it not only lays out timing, but levels of cash that may be required in the future and therefore should involve considerable thought. When incorporating uncertainty in projections we have found that including use of probabilities is an effective way to incorporating the risk and sensitivity to outcomes in a scenario analysis.
There are two ways in which such analysis can be communicated. The first is using a decision tree and the second is using binomial probability distribution. While the decision tree is self-explanatory, the binomial distribution provides a quantitative analysis, based on various likely outcomes of success or failure. We note that the use of binomial probability can be a very effective tool if used in conjunction with other historical financial performance metrics, while also considering the current and expected economic environment.
Similarly, arriving at valuations for larger set of outcomes can be more effectively computed using the Monte Carlo simulation as it is a better tool for evaluating all outcomes. In order to fully delve into the inner workings of such modeling you will need to stay tuned for a future article.
For the purposes of the example in this article we created a simple decision tree shown below. This decision tree below shows the decision path to concluding that an acquisition is the best decision. For this example we assumed that the acquisition was related to a product that is already established in the market and that acquiring was going do include costs to integrate the product in Supplement’s distribution system. Also, we assumed that Supplement does not have a history of launching products and so the risk and sales growth is predicated on that assumption.
2. Determine Free Cash Flow (Operating Cash flow minus Capital Expenditure)
The use of EBITDA may be a more prevalent substitute measure for cash flow and has its advocates, but EBITDA is often less likely to represent true cash flow especially with fair value accounting. It is for this reason that we believe Free Cash Flow (FCF) is more suitable for decision making purposes. Though Cash is like the Truth and does not lie, the calculation of Operating cash flow and the impact of lease vs buy decisions, do have a short to medium term impact on the level of FCF. However, it remains a better metric that is devoid of the use of different accounting methodologies. In short, FCF is a more trustworthy measure, reduces uncertainty, and provides a more accurate measure upon which to assess cash needs. Naturally, it is not without human intervention, as understanding how much debt is needed is based on future projections of a company’s profitability and growth. Therefore, one should not look at this in isolation of other qualitative factors and risk tolerance.
The table shows Projected Net Income and Free Cash Flow for our example, it incorporates the decision to acquire Complement Inc. and considers the various scenarios of economic conditions. While this shows a one-year view, typical projections will show the entire period for which the debt will be outstanding.
* Typically, Cash Coverage Ratio used to determine how much cash is available to pay interest should be greater than 2.
3. Determine the Gap in Cash flows required for the Growth/Acquisition based on the Projections
This step could easily be part of the above consideration when preparing projections. However, we thought it was worth noting it separately. As stated above, the funding gap (excess of cash needed beyond available cash) in cash flows required for various initiatives is fundamental to assessing debt needs.
At this point we should determine how much of a cushion is needed as you never want to go through debt financing repeatedly as debt issuance or debt financing has issuance costs which at times can be significant.
4. Determine your Cash Conversion Cycle and Ratio.
It is uncommon to see this metric in typical financial analyses, but it is essential, as it allows one to understand not only the amount, but the timing of cash needs.
Think about it… How do you know how much debt you need and what terms to negotiate, if you do not understand the timing and magnitude of your cash flow? The focus of this measure is to allow management to assess how the company can convert cash on hand into more and more cash. Is it not the ultimate reason why companies exist? We like to think of the Cash Conversion Cycle in the same way we go about our daily tasks to make money and provide value to our stakeholders. Firstly, we look at the timing of cash outflows in operations through the purchase and/or manufacture of inventory or cost of services provided, all the way to the timing of cash conversion/receipts through sales and consequently through the days it takes for customers to pay for inventory sold or services provided to them. Generally, the lower this number is, the better for the company. Basically, your cash conversion cycle can be used as a tool to measure management effectiveness. The Cash Flow Coverage Ratio (CCR) measures Cash against Interest expense to emphasize cash flow dedicated to interest payments.
5. Calculate Debt Service Coverage Ratio (DSCR), and Interest Coverage Ratio (ICR)
The DSCR is calculated in order to know the magnitude to which a company will likely have cash available to repay the principal and interest. Think of it this way… no financial institution in their right mind will consider loaning money to a company who has little to no chance of making money, and let’s face it…. you can’t repay debt if there are no profits. Again this necessitates the use of projections prepared on a reasonable basis that allows management to not only assess their ability to repay debt (including interest), but also to compare with historical ratios and if significantly different, be willing and able to explain to a board why historical trends will or will not likely re-occur, in the case where in the past they were in a profit or loss position in terms of positive or negative cash flow, respectively.
6. Model in Debt and Corresponding Interest
Simply put, there can be no meaningful projections, if other financing initiatives to execute growth are not included in such projections. What this means is that the model that is prepared to show the projected growth, must include the debt and interest inflow and outflows, in terms of initiation of debt and subsequent cash payments of principal and interest. It would make little sense to proceed if all of the profits are used to pay debt.
7. Determine the Target Debt-service coverage ratio (“DSCR”) and Target Debt
Ensure that there is sufficient capacity to generate returns and pay interest expense and principal. The table shows the financial data at the end of year 1 for our example but this would need to be computed for the entire period of the cash flows to determine the total impact.
* The typical ratio for these considered acceptable is greater than 2.
The table above shows the DSCR Ratio of 7.9 which shows the outstanding debt is 7.9 times the Net Income and would require 8 years of continued consistent Net Income in order to repay the debt. The implied assumption is that Net Income = Cash, as well all know that is not the case. The ICR of 2.54 shows that Interest Expense is 2.5 times of the EBIT which is reasonably good. The Target DSCR shows the target additional debt that Supplement can carry is $36 Million and the funding GAP was $20 Million which is significantly lower.
The calculation of DSCR includes net operating income divided by the total debt service of the entity. The net operating income being revenue less operating expenses, not including taxes and interest payments, while the total debt service being interest and principal payments during the period, plus lease payments.
The DSCR is a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, and lease payments. We believe that this ratio is not just a ratio, but a necessary metric which if well understood and calculated, can provide a reasonable assurance of the company’s ability to repay debt. However, there are shortcomings of using this ratio that should be considered to prevent over reliance on the measure. One such shortcoming is that the ratio traditionally uses operating income which for sophisticated companies and companies that have significant depreciable assets and/or whose receipts and settlement of revenue contracts be spread out over an extended period, the ratio may not fully represent the Company’s ability to make interest and principal payments on a timely basis. We continue to emphasize that the most accurate measure of a company’s ability to pay current debt obligations is cash flow and therefore, what better measure to use than operating cash flow. We acknowledge that this like any other ratio is for a point in time, so it is extremely important to understand how this ratio fares in the current period and throughout the expected term of the debt. One can only hope that the company’s management has a good handle on its ability to forecast cash flow reasonably well.
The level of debt a lender will accept is usually closely aligned with the level of the DSCR; a high DSCR normally equates to a higher risk tolerance by a lender to lend a higher amount, excluding considerations of collateral, cash reserves, guarantees or other mitigating factors. Other macroeconomic events will also affect any lending decisions.
SO HOW MUCH DEBT IS TOO MUCH DEBT?
To answer the question “How much Debt is too much Debt”, one must take all the above into consideration. Then, based on the results can one reasonably arrive at the optimal debt level and structure. Naturally, the simple answer is that too much debt is the point where a company is in jeopardy of not being able to service the debt, and when debt repayment is not being paid from excess profit levels required by shareholders. In short, it makes no sense to incur debt only to be able to make just enough profits to repay such debt. Companies must be able to have sufficient profits beyond their ability to repay debt and as such it is imperative that when in the process of assessing an acquisition or new product introduction, management must diligently consider all the factors we have outlined. Doing so will likely prevent, and most definitely reduce the risk of failure.