Getting to the Bottom of a Company's Debt
Amid the recent spate of corporate blowups, one thing has been overlooked: Most of the companies that have been driven into bankruptcy are not in that state because of accounting scandals, but because they simply have too much debt. Indeed, with corporate debt at an all-time high and revenue growth anemic, it's no coincidence that corporations declared bankruptcy in record numbers in 2001 and the first half of 2002.
For an individual investor, there's no quick way to get a handle on a company's debt load. The balance sheet, which lists short- and long-term debt, is only a starting point. To grasp off-balance-sheet debt--several common forms of which have exploded by a total of 250% since 1995--you need to delve into other sections of the financial statements, including the footnotes. Since one problem with debt disclosure is that it's rarely all in one place, this installment of The Fine Print--a series examining corporate financial disclosures--gives you a road map to getting a more complete picture of a company's indebtedness. Once you do that, you can compare the debt loads of similar businesses to see if a company is too much in hock.
When assessing a company's debt, start with the balance sheet in quarterly and annual reports. Among the items listed on the "liabilities" side of the ledger are the "current" or short-term debt obligations that must be paid down within a year, and the long-term debt that comes due after that. The 2001 annual report published by paper company Georgia-Pacific (GP ), for example, shows that the combined debt fell from $14.9 billion in 2000 to $12.2 billion in 2001.
That's good, but the footnotes reveal a cause for concern. In a table, Georgia-Pacific reports the debt payments that it must make each year through 2006. Since the $1.5 billion due in 2002 is equal to the company's entire cash flow from operations in 2001, it raised red flags among the credit agencies that rate the riskiness of corporate debt. "We were concerned," says Cynthia Werneth, a credit analyst at Standard & Poor's (like BusinessWeek, a unit of The McGraw-Hill Companies). To meet its 2002 obligations, Georgia-Pacific has renewed a $650 million bridge loan that could come due as early as February. It can also draw on $900 million available under a line of credit. But it needs to take additional steps to raise liquidity, because the new loan raises 2003's debt tab to $1.2 billion, Werneth adds. S&P put the company on negative credit watch on Sept. 12 for a possible downgrade to noninvestment-grade status. Georgia-Pacific spokesman Greg Guest says: "We have no liquidity issues, we have strong cash flow, and we fully expect to meet our debt obligations for 2003."
Next comes the hard part: looking for off-balance-sheet debt. Luckily, the most commonly used off-the-books transactions are fairly easy to track. Take leases. Instead of buying big-ticket items, such as buildings and aircraft, many companies lease them, in part to minimize debt.
But a lease that commits a company to a fixed payment schedule is really no different than a bank loan. For that reason, both S&P and rival credit agency Moody's Investors Service treat leases as if they were debt. In fact, one type of lease--a capital lease--is already on the balance sheet and can easily be added to outstanding debt. (Capital leases meet one of four requirements, including that they last for at least 75% of an asset's life.) In contrast, operating leases are only disclosed in a footnote.
In a footnote titled "Commitments and Contingencies," Georgia-Pacific reveals it is on the hook for $1.5 billion in operating lease payments. The company details the specific lease payments it is scheduled to make in each year from 2002 through 2006. Then, in accordance with accounting rules, it aggregates the payments due after that. Credit analysts don't add the entire $1.5 billion lease commitment to the company's debt load. Instead, their practice is to value future lease payments in today's dollars--so $1.5 billion would be worth about $1.1 billion, Werneth figures. Although this calculation is complicated, you can use a shortcut to arrive at an estimate. Take the current year's lease payment and multiply by 7, says Charles Mulford, an accounting professor at Georgia Institute of Technology.
Another common form of off-balance-sheet financing is securitization, or the sale of assets to an entity that often issues debt to pay for them. Banks, for example, sell assets such as loans and credit-card receivables. Other companies sell accounts receivable, or the bills their customers have yet to pay. Although securitizations seem like sales, often they are really more like loans. Why? Because in many cases, companies remain liable if a borrower or customer defaults. As a result, credit analysts consider many securitizations as debt. "The question is, has the company actually transferred the risk" associated with owning the asset? asks Brian Clarkson, head of structured finance at Moody's. "In most cases, they have not."
Some companies automatically add securitizations to debt. In a footnote, Georgia-Pacific reveals that it borrowed $1.35 billion against accounts receivable--an amount included in the short-term debt on its balance sheet. But in a footnote entitled "Loan Securitizations and Off-Balance-Sheet Activities" in its 2001 annual report, Bank One discloses that less than half of its $68.2 billion of credit-card loans are on the balance sheet. In accordance with Generally Accepted Accounting Principles (GAAP), the balance sheet reflects the loans the bank has decided to hold, while those it has sold are off-balance-sheet, says spokesman Thomas Kelly.
The disclosure rules on securitizations allow some deals to go unreported. Others are hard to find. In the case of banks, for instance, disclosure of credit-card securitizations is generally good. But they are less forthcoming when it comes to sales of auto, home equity, and commercial loans, says S&P banking analyst Tanya Azarchs. Moreover, it's difficult to discern how much risk the bank retains in these areas, she adds.
Make sure to check the "Commitments and Contingencies" footnote for guarantees--and potential associated losses--made on behalf of affiliates, customers, and others. Since management might be called upon to make good on its promises, conservative investors often count guarantees as liabilities, a move that accounting rulemakers are considering, as well.
Debt is also frequently discussed in the "Management's Discussion and Analysis" section of annual or quarterly reports. There, you might also find disclosure of conditions that the company's lenders require it to meet. This information can prove critical, since in some cases, failure to adhere to certain standards might cause lenders to demand immediate repayment or more collateral. For instance, when Moody's lowered energy company Aquila's bond rating to junk status on Sept. 3, the company became liable for an extra $192 million in collateral and bond payments. If S&P follows suit, it would trigger additional payments of $292 million.
Still, most companies keep such lender terms under wraps. Indeed, in a survey published in July, Moody's Investors Service found that 771 investment-grade U.S. companies had disclosed only 22.5% of 2,819 conditions that could force them to accept worse terms on debt agreements such as loans and bonds if their credit ratings were to fall.
Of course, once you ascertain a company's true debt load, the next step is to assess whether it's too high. One way to get a quick read on where a company stands is to examine the debt over time--and steer clear if you notice a consistent or sharp increase, advises Georgia Tech's Mulford.
You can also look up a company's credit rating at moodys.com or standardandpoors.com and compare its debt-to-equity ratio with those of companies with similar credit ratings (table). By doing so, you can get a sense for whether the company is highly leveraged compared with its peers, and therefore a possible candidate for a credit downgrade. At the least, downgrades often raise borrowing costs.
Sizing up a company's debt is tricky, but some help is on the way, since accounting rule makers are likely to adopt tougher disclosure standards on off-balance-sheet debt--especially where leases are concerned. Even then you're unlikely to get the whole picture, so you'll need to continue digging through the fine print.
By Anne Tergesen