Stability is the long-term counterpart of liquidity. Stability analysis investigates how much debt can be supported by the company and whether debt and equity are balanced. The most common stability ratios are the Debt-to-Equity ratio and gearing (also called leverage).
- debt-to-equity ratio = (Net debt) / (Shareholders’ equity)
- gearing = (Net debt) / (Net debt + Shareholders’ equity)
- Net debt = Interest-bearing debt – Excess cash.
Net debt is defined as interest-bearing long-term and short-term debt less excess cash in the business. Note that only interest-bearing net debt is included here, and other current liabilities are excluded as they are short-term and can impact on liquidity, but not stability. Excess cash is the cash held on the balance sheet that is not needed and exceeds the normal cash level required for business operations (usually 3%-5% of annual sales).
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Both Equity and Net Debt should be taken at market value as far as possible, otherwise book value should be used. Book values mostly record historical costs only and not “fair value”. For debt, unless the company has a high credit risk or interest rates have changed considerably, the difference between book and market value will be small. For equity, market values are usually considerably higher, at least when the company is operating as a going concern and is not in liquidation.
Note that while the cost of debt is usually lower than the cost of equity, and a company attempts to minimize its cost of capital by using debt, it is unwise and often disastrous to put a company in a situation where it can not pay its interest and meet its redemption payments as they fall due. So gearing is all about using the right mix of debt and equity to finance the business in the long term.
Different levels of gearing are regarded as normal across various industries, in particular depending on the ability of the business to generate a high level of cash and therefore bring protection from a risk of default, thereby reducing risk to debt holders. Even within one industry, some companies are more geared than others, especially those with stable profit and assets like land and buildings who are unlikely to fall in value quickly over time and therefore provide good security. When a company’s gearing is outside of the usual industry range, its debt can be expected to be downgraded, thereby increasing the cost of debt.
Gearing also varies with time and might temporarily differ from a target gearing. For instance, in the early 1990s an average gearing of 25% was typical for fixed network telecom operators in Western countries, whereas in 2005, gearing of 30%-40% was common for integrated all-purpose operators, reflecting the stronger acceptance in the industry for higher level of debt as well as the high debt level of operators that had engaged in expensive M&A and UMTS licence acquisition. Ofcom, the UK telecom regulator, uses a range of 10% to 30% as the optimal gearing for a UK mobile network operator, with 10% being considered as low gearing and 30% high gearing. Currently, mobile operators are seen as more risky than fixed-line or integrated telecom businesses as they are more specialised than integrated operators, and consume more cash, whereas the market dominance of most incumbent fixed-network operators, especially in voice, is seen as a cash cow and stabilizing factor. This might change though with the emergence of Voice over IP and increasing price competition.
According to Michael Pomerleano, a World Bank economist, gearing also varies by geographic zone, with gearing being typically lower in Latin Americas, which have often less access to debt in their own capital markets, but higher in Asian countries, where governments have encouraged state-owned banks to lend to companies without being too strict on their creditworthiness.
Other useful ratios here from a debt holder perspective are the interest cover ratio (also called times interest earned), the times burdened covered and the debt cover ratio.
- times interest earned (also called interest cover ratio) = EBIT(DA) / (Net interest payable)
- debt cover ratio (long-term view) = (Net debt) / EBITDA
The interest cover ratio indicates by how much profit would have to fall until the company is unable to pay its interest. EBIT and EBITDA are taken from the Profit & Loss account and can be seen as proxy for respectively Cashflow from operations and Cashflow after investment. Sometimes interest cover is calculated using cashflows from the Cashflow statement.
Finally, the debt cover ratio shows how many years of EBITDA would be necessary to reimburse company debt (principal) in full. For telecom network operators, a ratio lower than 2 is regarded as acceptable.