Tuesday, March 18, 2014

Risk management series: Financial risk

I think of debt as cheeseburgers. There’s nothing wrong with grabbing a great burger (I’m talking heart busters with more than 1,500 calories) every now and then. The problem is when you become a cheeseburger addict; you will get fat and bitches won’t want to have anything to do with you. Similarly, having a capital structure that consists of some debt can enhance returns on capital, but too much debt can destroy shareholder value. In this article, I will be talking about what I personally look out for when analysing a company’s financial risk.

The first thing I want to do is estimate the percentage decline in the company’s earnings before interest & taxes (EBIT) during a recession. You can come up with an estimate of the percentage decline in EBIT by looking at data from historical periods of economic stress such as the great financial crisis. I will then calculate the interest coverage ratio (EBIT/Interest expense). But instead of using the company’s current EBIT to calculate the interest coverage ratio, I will use my estimate of EBIT if a recession were to happen. I want to be reasonably sure that the company can service the interest on its debts with its operating profits even during recessions. If the company has a diversified stable of businesses and/or a geographically diversified customer base, then I wouldn’t mind if its interest coverage ratio is lower. A company can also have a lower interest coverage ratio if it has significant cash holdings and marketable securities that it can tap into to cover interest payments during rough times. But whatever it is, I will generally be uncomfortable if the interest coverage ratio (after replacing current EBIT with the estimated EBIT during a recession) is below 2.

I would also look at the company’s debt/equity ratio to make sure that the company isn’t overleveraged. A company with a high debt/equity ratio could still have a high interest coverage ratio as it could have taken on a lot of fixed rate debt when interest rates were low. However, such a company runs the risk of getting fucked by burdensome interest payments if it has to refinance its debts at significantly higher rates in the future. So, regardless of how high the company’s interest coverage ratio is, it’s still important to make sure that the company doesn’t have too much debt. I generally feel uncomfortable if a company’s debt/equity ratio is above 1 (however, some businesses like banks can afford to be much more highly leveraged).  

I guess I will end the article here. Just remember that you will drastically improve your odds of making money and fucking bitches/manwhores if you’re competent at valuing companies and you keep your eyes on both profits and risks. Thank you for reading. Take care and stay rational.     

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