by Joe Pimbley, Columnist & Featured Contributor
[su_dropcap style=”flat”]I[/su_dropcap]T WOULD BE A TREMENDOUS BENEFIT to investors, lenders, and all financial professionals if one could analyze a specific business and estimate its likelihood of failure. It is much easier to state this goal – for which one name is “credit underwriting” – than to accomplish the goal. Throughout the capital markets there are innumerable experts who devote careers to developing judgment and analytical skills for underwriting of lending risks to various types of entities (i.e., industrial companies, individual homeowners, hedge funds, countries, et cetera). Restricting ourselves to the financial considerations of default risk, we develop here the basic principles of credit underwriting.
It stands to reason that a company with no debt cannot default on debt payments. This company has payment obligations to employees and likely also to suppliers, so it does remain possible for this business to fail. But the likelihood of the company’s failure is less than it would be – all else equal – than if it had a significant debt repayment obligation. As a general principle, then, the default likelihood of a company increases as its debt increases.
There exist numerous meaningful measures of debt burden a few of which are: debt-to-EBITDA; EBITDA-to-interest; debt-to-equity; and debt-to-assets. The acronym EBITDA means “earnings before interest, taxes, depreciation, and amortization.” The EBITDA-to-interest measure is known as a “coverage” measure since the EBITDA numerator shows the proceeds available to pay interest on the debt in a given period while the denominator “interest” is this same interest on the company’s debt. Clearly, an EBITDA-to-interest value lower than 1.0 means the company cannot pay its debt interest from current revenues. That’s a bad sign! The other three ratios of debt-to-EBITDA, debt-to-equity, and debt-to-assets are “leverage” measures (also known as “gearing” in the UK).
Broadly, to have low likelihood of failure, a business should have high interest coverage and low leverage. An EBITDA-to-interest ratio of just 1.0 implies the firm can just barely pay its interest expense. Subsequent subtraction of depreciation and amortization will produce a negative net income. Thus, low EBITDA-to-interest coincides with low or negative profitability. Conversely, a comfortably high EBITDA-to-interest of, for example, 4.0 is much more likely to coincide with strong profitability.
By our definition above, a business with high leverage has a large amount of debt relative to EBITDA or to assets or, most likely, to both. The firm’s assets and EBITDA are the sources of cash to pay down the debt. See figure 2-1 in which we show a simple drawing of a highly leveraged company’s balance sheet in which the assets are $1 billion and the debt is $900 million. The equity – which must equal the assets minus the liabilities – is $100 million. Hence, the debt-to-equity measure of leverage is 9.0 (the $900 million of debt divided by the $100 million of equity).
Figure 2-1: Balance sheet of a highly leveraged company
Let’s imagine that $100 million of this company’s $900 million of debt is maturing soon. The company must repay this $100 million by selling $100 million of assets and paying cash to the lender or by simply borrowing another $100 million from a new lender and paying the $100 million cash proceeds of this new loan to the old lender. Virtually all businesses operate with this second choice. Mature companies prefer to keep their debt load somewhat constant rather than reduce assets to pay debt as it matures. Replacing old debt with new debt in this manner is known as “rolling the debt.”
This balance sheet strategy of rolling debt has risk, though. When a company is highly leveraged, it may be difficult to persuade a new lender to make the loan. This lending decision is precisely where and why the lender’s “credit underwriting” is important. How would an expert analyst view the borrower’s debt-to-equity leverage of 9.0? The expert may conclude that the leverage is acceptable if the business has a long and strong track record and appears healthy in the present.
But this expert – or perhaps another expert with a different view – may question the value of the company’s assets. Figure 2-1 stipulates that the value is $1 billion, but all such values are merely estimates or are determined by accounting convention which implies they may not be “real” values. If a more plausible value of the assets is just 5% lower (i.e., $950 million), then the company’s equity falls dramatically to $50 million since equity is just assets minus liabilities. The diminished equity means that the debt-to-equity leverage increases to 18.0 ($900 million of debt divided by $50 million of equity).
Thus, the expert’s risk assessment of the loan depends both on the value of the company’s assets and on the level of certainty of the value of these assets. The greater the uncertainty, the greater the risk since the true value of assets has higher likelihood of being lower than stated. Further, it is really the potential future value of assets that has greater impact on loan risk assessment. If, during the life of the loan, the asset value falls significantly from the current agreed value of $1 billion, then the assets of the company can be worth less than the $900 million of debt.
The word “insolvent” has two definitions in the financial world. One definition (“balance sheet insolvency”) states that an entity is insolvent when its liabilities exceed its assets. The second definition (“payment insolvency”) describes an entity as insolvent when it cannot pay its debt obligations as they come due. The two definitions are related but not identical. There exists, for example, a reasonable possibility in some circumstances that an insolvent firm by the first definition is able to pay a maturing debt obligation. It’s also possible that a firm with asset value greater than liabilities cannot pay a maturing obligation.
For the sake of this discussion, let’s just say that it’s bad to be insolvent by either definition. A business that is highly leveraged runs the risk of becoming balance sheet insolvent or as appearing to be near the point of insolvency due to questionable asset valuation. When such a nearly insolvent firm attempts to roll its debt, it may find few willing lenders.
In our example, the highly leveraged company has $1 billion in assets (possibly with some amount of uncertainty in the valuation) and $900 million in debt. We imagined that $100 million of this debt, a relatively small fraction, would be maturing in the near future. If new lenders are unwilling to give the company a new loan to pay the $100 million principal for the near-term maturity, the business would find it necessary to sell assets to pay the $100 million. A typical business would be “unhappy” with the situation since most of its $1 billion in assets would be highly illiquid and not intended for sale. But at least this sale of assets is conceivable. In its most liquid assets (cash, short-term securities, and accounts receivable, for example), the company may scrape together the $100 million.
But what if, instead of $100 million, this company has $500 million or more maturing within the same time period (such as the same year)? Clearly this is a much bigger problem and it would be unthinkable for the company to sell half its assets to pay its debt maturities in this contingency of new lenders not permitting the company to roll the $500 million of debt. Of course, it may well be that the year of the large debt maturity is “a good year” for the company and also for the lending markets. In that case, lenders will indeed roll the debt. But it is a risk and a gamble for a company to have a large fraction of its debt maturing in one time period. When this debt maturity period arrives, the company will have no control over whether it’s “a good year.
Up Next: “Lessons for Running the Business.”