The O'Brien Column: Balancing debt, cashflows and the ability to repay

By Peter V O'Brien

Friday 16th August 2002

Telecom's decision to reduce debt substantially over the next two years was sensible, even if the potential reaction of credit agencies to the company's balance sheet structure forced the issue.

Companies must keep an appropriate balance between debt, equity, cashflows and the ability to repay borrowings.

Telecom was far from a situation where it was "borrowing to go broke" but acknowledged the need to lower debt to preserve current credit ratings.

The group stretched itself with the debt-financed purchase of Australia's AAPT for $2.8 billion, an investment written down by $858 million in the accounts for the year ended June 30.

It was immaterial whether Telecom paid too much for the Australian company in light of subsequent events because the best analysis can come unstuck in the light of subsequent events.

Hindsight wisdom is easy. The key matter was the inability of the now expected cashflows to justify the investment's book value.

Telecom's debt structure could result in a credit rating revision if it remains at high levels. An adjusted rating does not mean a company is heading for the back door, unless the rating was already very low.

The company wants to maintain its current status and therefore will reduce debt. That made sense. It also raised the often overlooked issue of corporate debt relative to cashflows and reported profit.

Companies can earn and report profit while having negative cashflows, depending on the makeup of the "profit." They cannot service debt adequately and reduce it through regular repayment instalments unless they have positive cashflows.

A company could earn, say, $1 million in net profit in a given year but have a positive cashflow less than that amount and a debt repayment have a positive cashflow less than that amount and a debt repayment requirement of more than $1 million a year.

It would soon have a cash crisis under that scenario but could report regular profits and pay interest on the debt.

Credit agencies are not the only organisations reacting to such developments.

Lenders keep, or should deep, an eye on cashflows relative to the repayment regime. It is appropriate to say "or should keep" because some hotshot banks in years past failed to watch developments. They were stuck with large bad and doubtful debts from companies that were supposedly top performers in the late 1980s.

The banks picked up the tab later when it was obvious there was little chance of repayment.

Lenders and borrowers have learned since those days. There is general acknowledgement that the amount of debt and its relationship to a company's total financial structure must be closely monitored and adjusted in case it becomes unbalanced.

The emphasis on the issues in company reports is a different matter. Most companies note positive cashflows, debt reduction, sound debt to equity ratios and good interest cover.

That is admittedly a generalisation, because some companies "tell it as it is," irrespective of the news' nature.

Random examination of recent New Zealand reports show major companies are aware of relationships between, debt, cashflows and debt to equity ratios.

The Warehouse's report for the six months ended January 31 noted total debt, less cash on hand, was $202.8 million, "$15.9 million less than the same period last year." Net interest cover for the six months was 13.6 times (11.1 times in January 2001).

Those figures related well to others in the statement of assets, liabilities and shareholders' equity (known as the "balance sheet" in less sophisticated financial reporting days).

The Warehouse's debt was 63.8% of total shareholders equity, a reasonable figure, and was in a balanced relationship with total assets of $714.21 million.

Carter Holt Harvey's report for the six months ended June 30 said the balance sheet "remains especially strong, with net interest bearing debt $420 million less than a year ago, and the ratio of debt to total assets is now the lowest it has been in over a decade."

Operation cashflows to service the debt were positive $222 million, compared with negative $250 million in the corresponding period of the previous year.

Interest payments of $60 million were 20% lower than the $80 million paid in the six months ended June 2001.

Companies do refer to increases in debt, as shown in the report from GDC Communications for the six months ended June.

"During the period interest-bearing liabilities (borrowings and finance leases) increased by $800,000 from [$4.35 million] to [$5.15 million]. These borrowings were applied towards [$2.2 million] of investment expenditure during the half-year. Creditor balances were reduced by [$2.0 million], which contributed to a lower level of net cash inflows from operations than in the equivalent period of 2001."

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