The debt that a company owes its creditors is perhaps the single most important metric on a balance sheet. It affects so many things: credit rating and solvency risk, how much of the profit and cash streams will go to lenders, sensitivity to changes in trading, repayment issues, foreign currency exposure and so on.
Many of the businesses that have folded during the pandemic will have done so because of an excessive debt burden rather than a lack of fundamental viability. Despite debt’s obvious importance, though, many of the important details are missing for investors.
Covenants and currency
For a start, there is no requirement for a company to disclose its loan covenants. The usual excuse is commercial confidentiality, which falls apart on examination. Companies that are distressed can struggle to win business, but I know of no example where a company appeared healthy but was close to a covenant breach; the opposite is usually the case.
Creditors and investors generally ask about covenants only when the distress has already become apparent and they want to know what impact a breach would have. Refusing to disclose covenants when distress is visible makes a bad situation worse.
Another missing piece of information is the effective currency. I used to follow a Swedish company that bought a large Japanese competitor and funded the acquisition with yen debt without telling anyone. The idea was to provide a natural hedge for both the income statement and balance sheet.
Many of the businesses that have folded during the pandemic will have done so because of an excessive debt burden rather than a lack of fundamental viability
Unfortunately, the expected profits never materialised and the yen appreciated suddenly and unexpectedly. As a result, the stated debt in krona ballooned in a way that no investor had anticipated. The fact that the unprofitable local assets had also appreciated was not much of a comfort.
Other culprits
Not knowing the covenants, coupon or currency of a company’s debt is obviously undesirable, but the reality can be even worse. Many companies own 51%–90% stakes in important subsidiaries. For a 75%-owned business, 25% of the debt belongs to someone else with no disclosure requirement. The same comment also applies to majority-owned cash. The coupon or interest rate may well be public, but a lot of debt is swapped from, say, fixed to floating rate, and the effective rate then becomes opaque at best.
Advance payments are a further complication. In my view, they are analogous to debt; they come with an obligation to deliver goods or services that will cost money to provide. Most companies treat advances as cash, which can come as a rude shock if the unit is subsequently sold.
Companies that have captive financing businesses, such as car leasing, can present particular difficulties. The debt that funds the leasing business is asset-backed, and the interest is in effect paid by the lessee. One can therefore argue that the leasing debt does not belong to shareholders.
In practice, though, leasing debt can be surprisingly hard to establish with confidence without voluntary disclosure. There are also grey areas about parent-company guarantees, rental businesses, transfer pricing, residual value risk and so on. Large captive leasing operations make investors nervous, and with good reason.
Standard fuzziness
Some of these problems should in theory have been addressed by the amendment to IFRS 7, Financial Instruments: Disclosures, which requires companies to reconcile opening and closing debt. In practice, the vague wording of the amendment, and the absence of any reference to net debt, has meant that this welcome initiative has been less successful than hoped. Some companies have provided useful information, but many others have just introduced a footnote of limited utility.
The underlying problem here is that the International Accounting Standards Board doesn’t seem to understand what investors want and why. As always, the solution is better voluntary disclosure.
