Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Measuring financial risk and cash conversion cycles
In the second part of our look at key aspects of a balance sheet we move beyond the basics to focus on some of the red flags pertaining to weakness in a company’s finances.
Net debt to EBITDA
To help provide some grounding, we take a closer look at the net debt to EBITDA ratio to explain what it is and how it can be used in relation to a company’s balance sheet.
While EBITDA (earnings before interest, taxes, depreciation, and amortisation) is considered a proxy for cash flow, it should be used with caution for companies which own a lot of physical assets.
When a company buys physical assets, it is required to depreciate them over their useful life. This isn’t a real cash item, but it is a real cash expense because assets need to be replaced. This means ignoring it, which EBITDA does, can overstate cash flow.
With that caveat out of the way, let’s move on to the ratio. The ratio is used by banks and credit analysts to measure the riskiness of lending to a company. Net debt is calculated as short and long-term debt minus cash.
The idea is that higher net debt in relation to the annual cash flow (as measured by EBITDA) implies it will take longer to pay off the debt and therefore increases risk.
Banks specify the maximum amount of net debt a company can have in relation to EBITDA as well as other measures designed to protect their loans.
The tests related to banking facilities are called banking covenants and can be found in the notes to the report and accounts. If these are breached, the bank may ask for its money back.
The required ratio level will differ by industry and is based on capital intensity and expected growth rate of EBITDA.
A ratio above three is considered at the upper threshold for an investment grade rating. Investment grade means that the company has a relatively low risk of defaulting on its debts. A ratio above four or five is considered very risky.
Taking a real life example, food retailer Sainsbury’s (SBRY) net debt including leases as reported at its interim results on 5 November 2020 was £6.2 billion while EBITDA was £2.2 billion resulting in a ratio of 2.7 times.
Sainsbury’s has been targeting a reduction in gearing and expects to reduce net debt by at least £750 million in the two years to 2022.
When analysing a company’s financial obligations don’t forget to check its pension liabilities. Older companies may have defined benefit pension schemes which require them to fund pensioners in retirement.
The assets and liabilities of the schemes can be found in the notes to the accounts. Where there is a deficit, it is prudent to take this long-term debt into account when measuring indebtedness.
Sainsbury has a defined pension scheme surplus of around £1 billion. It would be tempting to count the surplus as reducing the company’s debts, but it isn’t clear whether it belongs to the workforce or the company and its shareholders.
Pension fund deficits can topple mergers and acquisitions because of the power given to trustees which act as powerful creditors in the event of a change of control of the company.
We have already touched upon current assets and current liabilities in relation to liquidity measures like the quick ratio which is current assets divided by current liabilities. A measure above 1.2 is considered healthy.
Current assets minus current liabilities is equivalent to the working capital requirements of a business. It is important because even a profitable business can go bankrupt if it runs out of cash in the short-term.
There are three components of working capital: trade receivables; trade payables; and inventories. Most businesses have positive working capital (a cost) but it can be negative when a company gets cash from selling products before it must pay its own suppliers. Food retailers are a good example and we use Sainsbury’s as a working example later.
This bolsters short term funding and reduces liquidity risk. It also means that growth is self-funded, which is a very attractive financial attribute.
Trade receivables usually comprise a big proportion of working capital and they represent money owed by a company’s customers. Payment or credit terms vary from a few days to 90 days. The longer the cycle the longer it takes to collect cash.
That’s fine if a company is paying its own suppliers on a similar cycle, but the longer the timing gap, the more capital is tied up. A company’s own outstanding invoices are called trade payables.
To fulfil new orders a company will need to make finished products and have inventory available to meet anticipated demand. Inventory is therefore an important part of working capital.
All three components affect how long it takes to convert revenues into cash which is referred to as the cash conversion cycle (CCC).
Fast-growing capital-intensive businesses require a lot more working capital than capital light businesses.
Days Sales Outstanding (DSO)
This calculates the average number of days it takes to collect receivables. Often the amount of sales made on credit aren’t revealed in the accounts. In this case it’s still useful to calculate DSO using total sales.
Annual DSO is calculated as receivables divided by sales and multiplied by 365 to arrive at the number of days.
Each industry will have its own standard payment terms, so it is more insightful to look at trends in DSO. Taking longer to collect receivables can be a sign of distress and increase the risk of future bad debts.
Days Sales of Inventory (DSI)
This measure calculates how many days it takes for inventory to turn into sales. Average inventory is used to iron out seasonal effects where a company builds inventory ahead of busy trading periods.
DSI is calculated by dividing average inventory by cost of goods sold, multiplied by 365 to arrive at the number of days.
Days Sales Payable (DSP)
This measures the average number of days that a company takes to pay its trade creditors. A higher value may be a red flag signalling a company’s inability to pay its bills on time.
By putting all these components together, it is possible to calculate a company’s cash conversion cycle (CCC).
Taking longer to convert sales into cash can be treated as a red flag and prompt further investigation into the reasons for the deteriorating trend.
The CCC is calculated as DSI + DSO – DSP. In other words, the formula calculates a company’s short-term cash inflows minus cash outflows.
We have extracted the relevant data from Stockopedia for retailer Sainsbury’s to illustrate the cash management principles we have discussed.
The first thing to note is that Sainsbury’s has negative working capital of around £1.1 billion because it collects cash more quickly from its customers than it pays its suppliers.
The table shows that the company receives cash in two days while it pays for its supplies roughly every month, although the time has increased over the last few years, suggesting the company has been squeezing payment terms for suppliers.
On the other hand, it has taken the company longer to convert inventories into cash which can also be seen in the company’s lower inventory turnover ratio.
This ratio shows the number of times that Sainsbury’s sells and replaces its stock of goods over the year and it has fallen by a third since 2012 to 15 times a year from 22 times.
However, it looks like 2020 was the outlier which is probably down to increased demand during the Covid-19 pandemic as people stockpiled food before the first lockdown as well as spending more time at home.
In other words, the company purposely built larger inventory to meet anticipated demand. It will likely normalise over time.
Next week we will pull everything we have learned so far on company accounts to analyse an individual business from scratch.