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How
to Spot an Impending Bankruptcy
Stock financial analysis
The Enron and
Kmart bankruptcies demonstrate yet again that we can’t depend on
market analysts to keep us out of trouble. Yet, anyone with Internet
access could have figured out that owning Enron and Kmart was risky
business months before they finally folded.
Instead of
complaining, it’s time for investors to wake up and smell their
calculators. Here’s how to detect future Enrons and Kmarts.
Why Firms
Go Bankrupt
First of all, companies go bankrupt for a variety of reasons. Some are
cash-burning startups that run out of money and can’t raise more.
Sometimes, established firms choose bankruptcy because they are facing
huge costs arising from litigation, for instance, asbestos-related
lawsuits.
Most
companies however, fail because they’ve accumulated large debts, and
now their income doesn’t cover the loan payments. In this column,
I’ll focus on identifying firms with high debt-related bankruptcy
risks.
Bankruptcy
Candidate?
Most companies won’t
go bankrupt anytime soon. Hence, since we’re only looking for
debt-caused failures, we can save time by eliminating low-debt firms
first.
The total
debt to equity (D/E) ratio will do the job. It compares a company’s
combined long- and short-term debt to shareholders’ equity, or book
value. The D/E ratio is 1.0 when debt equals equity, and high debt
companies have higher D/E ratios than low debt companies.
Experts
consider companies with D/E ratios below 0.5 as low-debt. So, I’ll use
0.5 as the cutoff, meaning that only companies with D/E ratios of 0.5
and above will be considered debt-related bankruptcy prospects.
I analyzed
Enron based on reports that became available on three different dates;
its December 2000 fiscal year report, available April 2, when its shares
were trading in the high $50 range, its June 2001 quarterly report,
available August 14 ($40 share price), and finally its September 2001
quarter report released on November 19 ($9 share price). Enron’s D/E
ratios corresponding to those reports were 0.9, 1.1 and 1.4
respectively. So Enron qualified as a bankruptcy prospect each time.
I analyzed
Kmart using the discount retailer’s January 2001 fiscal year report,
available March 22 ($8 share price), and again using its October 2001
quarterly report, available on November 22 ($7). Kmart’s January 2001
D/E of 0.5 put it only marginally into the high-debt category, but its
October 0.8 D/E firmly qualified it as deserving further scrutiny.
Debt/Income Ratio
Carry a high debt load isn't bad if the company can use the funds it
borrows productively—such as making a 15 percent return on funds that
only cost it 8 percent to borrow.
Corporate
credit analysts favor EBITDA, an acronym meaning earnings before
interest, taxes, depreciation, and amortization,
to gauge a company’s ability to pay its debts. In their view, a
healthy company’s total debt should be no more than five times its
EBITDA.
If the debt
to EBITDA ratio exceeds a predetermined level, typically seven or eight,
it can trigger a loan repayment demand from the lender. A repayment
demand is a big deal, and can cause a company to fail. Since everybody
loses when a company fails, hitting the trigger level doesn’t
necessarily mean that the loan will in fact be recalled. However, at a
minimum, it means that the company will find it difficult to borrow
additional funds, which in itself can be a problem.
Given its
importance, we’d like to see the debt to EBITDA ratio for companies
that we’re analyzing. Unfortunately, it’s not that simple. For one
reason, companies can be very creative when deciding what constitutes
debt.
For instance,
Bethlehem Steel, one of last year’s bankruptcies, reported $853
million of long-term debt on its December 2000 balance sheet. However
the balance sheet also showed another $2.6 billion listed as
“additional liabilities,” which in this case, refereed to retirement
benefit obligations that were not included in the debt total. In fact,
Bethlehem's long-term debt totaled more than $3 billion, not the $853
million listed.
We can handle
this problem by using total liabilities, which includes all forms of
liabilities, regardless of how they’re labeled. For most companies,
the value of total liabilities is identical to, or slightly higher than
the total debt number.
Companies can
also be creative when tabulating EBITDA, but the biggest problem with
EBITDA is that it isn’t listed on most Web sites’ financial
statements.
As an
alternative, we can get similar results by using “operating income”
in place of EBITDA. Operating income is the same as EBITDA, except that
depreciation and amortization are deducted. So operating income will
usually be a smaller number than EBITDA. This substitution may raise
some analysts’ eyebrows, but as you’ll see, it appears to work just
fine.
Thus, my
version of the debt/income ratio becomes total liabilities divided by
operating income. Both of the elements in my ratio are standard entries
found on most financial statements. Always use the most recent
liabilities figure and the last 12-months’ operating income.
My
debt/income ratio values will be higher, typically by at least 50
percent, than the debt/EBITDA ratio that it replaces. As a result, the
equivalent danger threshold should probably be in the 11 to 12 range,
and perhaps higher, compared to the conventional ratio’s 7 to 8
trigger range.
Also,
you’ll find more negative numbers when you use operating income
instead of EBITDA in the ratio. That’s not a problem since negative
operating incomes correspond to low EBITDA values that would have
produced high debt ratios, still tagging them as potential bankruptcies.
You should consider all firms with negative operating incomes (and high
D/E ratios) as bankruptcy candidates.
Enron’s
June debt/income ratio was marginal at 14, but its December 2000 (28)
and September 2001 (52) debt/income ratios showed it to be a strong
bankruptcy candidate.
Kmart’s
operating income was negative in January 2001, making it an automatic
bankruptcy prospect. Kmart’s October quarter’s 39 debt/income ratio
was second only to Enron’s 52 among the 28 companies that I checked.
Interest Coverage
Companies with high debt ratios are not bankruptcy candidates if they
produce sufficient income to cover their interest payments and other
normal expenses. You can find out if that’s the case by checking their
“interest coverage ratio,” which is the operating income divided by
their last 12-months’ interest payments.
Healthy
companies’ interest coverage ratios typically range upwards of 4.
However, I spotted high-debt companies in my research with ratios around
1.5 that didn’t fail, so I’d keep the threshold in the 1.0 to 1.5
range.
Enron’s
interest coverage ratios were 2.3 in December 2000, 2.1 in June 2001,
and a flat zero in September. So the September report was the first
instance when Enron gave a flat-out bankruptcy signal.
Kmart showed
negative operating income in its January 2001 report, and its October
quarter interest coverage ratio of 0.8 also qualified it as a potential
bankruptcy.
I tested
seven other companies that failed last year, with results similar to
what I’ve described for Enron and Kmart. I also tested 21 companies
that didn’t file for bankruptcy, and came up with only one false
alarm. Computer Associates satisfied all the requirements for a
bankruptcy candidate, but it didn’t go bankrupt.
You can find
the data for this analysis on many Web sites. I used Multex Investor (www.multexinvestor.com)
to research this column. The operating income and interest payment data
lives on the income statement, the D/E ratio is shown on the Snapshot
page, and everything else can be found on the balance sheet.
Nothing works
all the time, and I’m sure that this strategy will have its share of
hits and misses. If you know of any other relatively easy approach that
works better, let me know.
published 1/28/02 |
