INTEREST EXPENSE/EBITDA.
Previously, with regard to the ‘EBITDA Margin’ and the ‘Pretax Profit/ Capital Employed’ ratio, I stated that I could very well be "preaching to the converted" for most who read those posts.
The same would apply to the following content.
However, if there are those that find it of interest, or of practical use, then it would certainly have been worth the effort.
The third criteria to interrogate when analyzing an Industrial company is the impact of the company’s long term interest bearing debt on its Income Statement.
It’s quite common to read that the ratio of long term debt to equity on its Balance Sheet should not exceed a particular ratio. Some will use 0.5. We tend to be more demanding and look for a ratio of less than half that number.
However, if that ratio is high it may not be a show stopper if the effect of the debt expense on its Income Statement is not excessive. It could be that a company requires plant or equipment over a relatively short time period in order to expand its business or it may want to take advantage of a specific and perceived upcoming opportunity.
As a result the company may decide to borrow money and preferably add this borrowed money to what it has available from its accumulated Reserves to make the purchase, etc .
It could also be the case that a company borrows money when interest rates are low which reduces the impact of Interest Expense.
Ideally we would prefer that Capital purchases should be paid for from accumulated bottom line profits, because it’s not that often that the cost of debt is less than what one could obtain by investing those Profits in the capital market etc... But there are times when “needs must”.
What would be a show stopper, in our opinion, is when the cost of this debt erodes too much of a company’s profit that is left over after the deduction of Cost of Sales and Running Expenses.
In other words the ratio of Interest Expense to EBITDA is relatively high.
In the following link there is reference to the EBITDA Margin which we regard as the first filter of a company’s potential Profit on its way down the Income Statement .....
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.... and the more Revenue left over after deduction of its compulsory expenses, at this level, the better it is for the company.
Therefore if we see an EBITDA Margin of, say, 25% then that’s a good sign.
Now if we have an Industrial company whose Interest Expense is so high that it erodes much of that left-over Revenue, such that its Margin is now down to, say, 10% to 15% then this is a company that may best be left alone.
We suggest, therefore, that one interrogates the ratio of INTEREST EXPENSE/EBITDA.
We prefer to see this ratio not greater than about 10% to 12% to ensure the minimal impact of debt expense on the company’s Operating Profit and ultimately its Bottom Line. |
