In last issue's Investor's College, we discussed the fact that corporate insolvencies aren't normally the result of a sudden misfortune. Instead, they tend to be the gradual and inevitable result of poor underlying economics. These poor economics are typically revealed by a low return on equity and weak cash flow (which were discussed in the Investor's Colleges of issues 170/Mar 05 and 171/Mar 05 ). But as the end draws near, there are some signs of more immediate trouble and these 'landmines' are the topic of this issue's article.
If poor economics are the long-term cause of most insolvencies, then debt—and the interest on it—is the short-term cause of almost every single one. So rising debts over several years are a bad sign, but the omens are more immediate when those debt levels start to look uncomfortable. Companies prefer to operate with a lot of headroom, so you have to be sceptical when that headroom starts to evaporate.
So what's enough headroom? One thing to look for is deteriorating interest cover. This is the amount of times that a company's earnings before interest and tax covers its net interest bill. Three times might be OK for the most reliable businesses, but you should expect cover of at least five times for most companies. For cyclical companies, you'd hope to see no debt at cyclical high points and cover of at least five times towards the bottom of the cycle.
If the operations can't be relied upon to cover debts, then the next step might be the sale of quality assets. You'd hope that a company would keep its best assets and sell its worst, but when they get into trouble it can be the other way around. After all, the dreadful assets that are burning through cash are probably not saleable, so a fire-sale of the better ones may be used to keep the show on the road. HIH Insurance was a case in point; it sold a substantial part of its most profitable local insurance business to German insurer Allianz in 2000, only months before falling into administration.
Visit The Intelligent Investor for the rest of this article on The minefield of insolvency to find out more on sharemarket terms and dividend yield.