When corporate debt becomes a problem
The latest edition of the Link UK Debt Monitor shows corporate debt in the UK is at its highest level on record having expanded for an eighth consecutive year.
To quote the report: ‘Net debt has now risen by three quarters since the low point reached in 2010/11, when companies were still adjusting to the disruption caused by the financial crisis and subsequent recession.
‘The £24.2bn increase in 2018/19 comes at a time when UK plc profitability is under pressure: operating profits were flat year-on-year after growing strongly over the previous two years.’
Just how concerned should investors be and is borrowing cash inherently a bad thing? First of all, it is important to remember than not all debt is created equal.
Just look at your own life, nobody would describe taking out a mortgage with a sizeable deposit as an inherently reckless act. However, running up substantial bills on credit cards could see you run into trouble sooner rather than later.
Factors like the predictability of your income (for example are you paid a regular salary, or do you work on a freelance basis?) might also have some bearing on how much indebtedness would impact on you.
The same applies to companies. There are two main ways of funding a business, debt and equity. The latter is typically seen as being more expensive. However, clearly if a firm borrows money it will have to pay interest and this money will eventually have to be repaid.
Gearing, calculated by dividing net debt by total assets minus liabilities, is one way of measuring how indebted a company is.
A TOXIC MIX
There’s no hard and fast rule for an appropriate level of gearing but upwards of 50% is probably on the higher side.
Where high financial gearing becomes a serious issue is when it’s combined with elevated operational gearing, where a slight drop in revenues could lead to a huge decline in profits due to a firm’s high and mainly fixed costs.
And if the company in question operates in an industry which sees demand fluctuate in line with the economy, or even worse is facing some kind of structural decline, then this can add up to a very toxic mix.
This has been brought home in rather brutal fashion to shareholders in travel operator Thomas Cook (TCG).
Spending on holidays is clearly linked to economic conditions, Thomas Cook, which operates its own airline, has plenty of fixed costs and therefore its net debt of a little more than £1bn becomes a really big issue.
Ultimately the company has had to agree a £750m rescue plan with its lenders, supplemented by a further £150m announced on 12 August. This will be achieved by swapping debt for shares in the company, meaning existing shareholders’ positions are likely to be worth very little going forward.