Cashed up
A reader asked me a question on my recent blog post on Nick Scali (ASX: NCK) and I thought I would make it the topic for today. The reader asked; “Is there a reason why the company would prefer to increase debt rather than fund with cash reserves?”
This is a very good question but is quite difficult to answer as the decision to borrow is usually made by the management of the company on a case by case basis.
In theory, a firm would borrow money whilst having cash on its balance sheet if it believed that the opportunity cost of that cash is higher than the interest rate payable on the debt. In today’s low interest rate environment, this would not be a surprising finding. In addition, firms may wish to borrow at low rates now in anticipation of higher rates and/or more stringent loan conditions/repayment schedules in the future.
As you can tell the theory is very broad and could be applied to a vast array of scenarios, hence the reasons for borrowing are usually very company specific. For example, Apple is well known to have billions of dollars on its balance sheet; however a large chunk of these monies are banked outside of the US. Apple raised capital via bonds in 2013 and when asked why, the CEO (Peter Oppenheimer) responded that Apple would need to pay the corporate tax rate if the cash were repatriated to the United States.
Implicitly (assuming Apple is rational), the firm suggests that they anticipate the cost of debt to be lower than the cost of taxation in bringing those funds back to the United States. Those funds may not necessarily remain idle as they can be invested in others parts of Apples business outside of the US, or alternatively used for a foreign acquisition.
As for Nick Scali, the large increase in cash appears partially due to higher customer deposits. Also it appears that they are using debt to expand their portfolio of stores and for general payables. As an investor, would I prefer less debt as opposed to more? Of course, but as long as their capacity to repay lenders remains sound I would not be too worried.
The best course of action in many of these cases is to ask the company about the motives behind their borrowing, thus enabling you to be the judge of whether the action is commercially sensible or detrimental to your wealth as a shareholder.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
INVEST WITH MONTGOMERY
Andrew Legget
:
The unfortunate thing about debt is that you have to pay it back at some point. Debt by itself isn’t the problem, it is the ability to repay and the way it is used that causes problems.
I remember when JBH had a D/E ratio higher than 1. I read comments (not necessarily on here) that this is terrible but they still had interest coverage of a healthy 3-5x earnings before interest and tax. I was still quite comfortable. These days i pay more attention to the interest coverage ratio than D/E.
As you say Scott, i would obviously prefer that the company has no debt as this means there is less risk and i don’t have to share the returns of the business with the banks.
Roger Montgomery
:
Just be mindful of the rate of interest being paid too. If interest rates are low, coverage can be higher…
Julian Watt
:
Do companies respond to such questions from shareholders outside of an AGM?
Roger Montgomery
:
Surprisingly yes, some do.