Debt demystified - Part 3

Yogi Berra, the legendary catcher for the New York Yankees, once said that 'in theory there is no difference between theory and practice, but in practice there is'. The verbally-challenged Berra could have been commenting on investment analysis as much as anything else. The more you play with numbers from annual reports, the more quickly and easily you'll understand what they're telling you. So we're devoting this issue's Investor's College to practicing what we've learnt about debt in the last two issues.

In those articles we laid out three standard tests to measure a company's indebtedness and how well it's handling the interest burden. The first was the net debt-to-equity ratio (covered in issue 148/Mar 04) and the second and third were the profit interest cover ratio and the cash flow interest cover ratio (both covered in issue 149/Apr 04 ). So we're going to ask you to work out those ratios for Tempo Services , for 2002 and 2003, from figures we've taken from its 2003 Annual Report. To what extent do you reckon Tempo is toppling under a mountain of debt? Well, how did you go? Compare your answers with these and you can see how your theory is travelling in practice. Note that all the numbers given are in thousands of dollars, but we don't need to convert any of them since we're only interested in the ratios between them.

Net debt-to-equity ratio

The net debt is just the sum of the short-term (current) and long-term (non-current) debt, minus the cash balance (the figures come from the statement of financial position).

2003 net debt=11,525 32,442–2,681=41,286

We then take the net debt (41,286) and divide it by the total shareholder equity (33,876), to give a net debt-to-equity ratio of 121.9%.

For 2002, the sum is (4,629 29,633–10,799)/40,278=58.3%.

Profit interest cover ratio

For this one, we start by adding the borrowing costs back onto the net profit (the figures come from the statement of financial performance).

2003 borrowing costs net profit =3,630 7,347=10,977.

We then take this figure (10,977) and divide it by the borrowing costs (3,630), to give us a profit interest cover ratio of 3.0.

For 2002, the sum is (2,775 11,608) / 2,775 = 5.2. 

Cash flow interest cover ratio

To get this, we start by taking the interest paid figure and adding it back to the net operating cash flow (the figures come from the statement of cash flows). 2003 interest paid net operating cash flow=3,147 5,837 =8,984.

We then divide this figure (8,984) by the interest paid (3,147) to give us a cash flow interest cover ratio of 2.9. For 2002, the sum is (2,228 20,269) / 2,228 = 10.1.

So we can see that Tempo is indeed carrying a large pile of debt. At June last year, it had more debt than it had equity—about 122% as much in fact. In terms of servicing that debt, the cash and profit ratios both show that the interest bill is covered about three times. That's tighter than you'd normally like to see, particularly since the profit and cash flow figures have been so variable, but there is still some breathing space. Perhaps of greater concern is that the figures have deteriorated between 2002 and 2003 and the next step is to try to work out whether that trend will continue. There's more about that in the Tempo review in issue 150.