Financial Strength Is Not All About Gearing: Learning from Z-Score and REITs

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Feb 20, 2013
It is all easy to calculate gearing or the debt-to-equity ratio for a stock and conclude that a stock is financially risky because it exceeds a certain quantitative cut-off. I myself have been guilty on many occasions of making such mistakes.

I will like to share some insights from the Altman Z-Score and my experience with REITs in evaluating the financial strength of companies.

The Altman Z-Score incorporates parameters such as working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, market value of equity/total liabilities and sales/ total assets.

Earnings before interest and taxes/total assets is one of the coverage ratios commonly used and should be used in connection with gearing in assessing the financial strength of a company. A company with consistently strong earnings and free cash flows have the capacity to take on more debt since they generate sufficient cash flow (with buffer) to pay the interest payments and even the entire debt balance outstanding in some cases.

Market value of equity/total liabilities and sales is another interesting parameter, since gearing is typically calculated as debt divided by book equity. For some stocks, because of accumulated losses or accounting distortions, their book value of equity is small or even negative. Stocks like this appear to be highly geared on a cursory glance, but could be financially strong stocks with low net debt-to-EBITDA ratios.

In my research on REITs, it is interesting to note that REITs typically disclose more information in terms of quality and quantity with regards to their financial position. These include debt maturity break-down on a yearly basis and the proportion of floating rate debt.

A longer debt maturity reduces refinancing risks and allows management to focus on running the business and not be embroiled in lengthy discussions with bankers. In a difficult credit environment like the 2008 global financial crisis, companies with a shorter debt maturity or significant amounts of debt maturing within a year or two, will face problems in refinancing their debt when it is due.

Floating rate debt is vulnerable to interest rate fluctuations, creating variability and volatility in a company’s interest rate expense. Managers are not traders and should not act like them, betting on interest rate movements .