Why Balance Sheet Matters

Analyzing a company’s balance sheet is crucial for dividend investors because it provides insights into the company’s financial health and stability, which are essential factors in maintaining and growing dividends. An overlevered balance sheet, characterized by a high level of debt relative to the company’s earnings or equity, is one of the main reasons for a dividend cut.

An overlevered balance sheet can pose several risks to a company’s dividend-paying capacity:

1. Increased Interest Expenses: Companies with high levels of debt typically have higher interest expenses, which reduces their overall profitability. With less profit available for distribution, there is a higher likelihood that a company may need to reduce or eliminate its dividend payments to maintain liquidity and service its debt obligations.
2. Reduced Financial Flexibility: Companies with high debt levels and poorly structured debt maturities have limited financial flexibility, as they are more vulnerable to economic downturns, rising interest rates, and changes in credit market conditions. This decreased financial flexibility can lead to dividend cuts, as companies may need to divert their resources towards debt repayment and will struggle to refinance on favourable conditions when needed.

Key Balance Sheet Ratios for Dividend Investing

1. Debt/EBITDA Ratio

The Debt/EBITDA ratio is a key financial metric that helps investors evaluate a company’s leverage and ability to service its debt.

Debt/EBITDA = Total Debt / EBITDA

Where:

• Total Debt is the sum of a company’s short-term and long-term debts.
• EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, which is a measure of a company’s operating performance.

For dividend investors, a lower Debt/EBITDA ratio is generally more desirable because it indicates that the company has moderate debt levels in comparison to their earnings potential, making it more likely to sustain and grow its dividend payments. A high Debt/EBITDA ratio, on the other hand, may signal that the company is heavily burdened by debt and could face difficulty maintaining or increasing its dividend payouts as more resources will be diverted towards servicing the existing debt or trying to reduce it.

For most companies a <3x Debt/EBITDA ratio is considered a safe level.

However, cyclical companies that rely on a particular commodity price(such as oil producers) or strong consumer spending (retailers) should carry lower debt levels as their profit generation capacity fluctuates over time.

A <1.5x ratio is more appropriate for cyclicals to make sure that they weather downturns.

There are also businesses with very stable cash flows such as net-lease REITs, that can comfortably carry higher debt loads because they can predict their cash flows with high accuracy going forward.

A Debt/EBITDA ratio up to 6x is acceptable to me in those cases.

2. Interest Coverage Ratio

The Interest Coverage ratio is another important financial metric for assessing a company’s ability to service its debt.

Interest Coverage Ratio = EBIT / Interest Expense

Where:

• EBIT stands for Earnings Before Interest and Taxes, which is a measure of a company’s operating performance.
• Interest Expense is the total cost of interest payments on a company’s outstanding debts during a given period.

A higher Interest Coverage ratio indicates that the company has adequate earnings to cover its interest payments, reducing the likelihood of financial distress.

Dividend investors should look for companies with a higher Interest Coverage ratio, as it demonstrates the company’s ability to meet its interest obligations without jeopardizing its dividend payments. A low Interest Coverage ratio may indicate that the company could struggle to maintain or increase its dividend payouts due to insufficient earnings to cover its interest expenses.

In most cases I look for an Interest Coverage ratio of >8x, but this highly varies between sectors as well.

Importance of a Well-Staggered Debt Maturity Schedule

Companies usually take on loans with different amounts maturing (principle needs to be paid back) at different times. During the term of the loan they just pay the interest on it and the principle needs to be paid back at maturity. As credit market conditions and interest rates are constantly changing, it’s important that the company doesn’t have too large of a % of debt maturing at any point – rather it’s well spread out over many years.

A well-spread-out debt maturity schedule is vital for dividend investors, as it reduces the risk of a company facing significant debt refinancing at any given time. When a company has a large portion of its debt maturing simultaneously, it may struggle to refinance, especially during times of economic uncertainty or rising interest rates. During those periods the company might find itself having to refinance on much worse terms than previously, which can lead to increased interest payments and reduce cash flows. This in turn could lead to financial distress and potentially impact the company’s ability to maintain or grow its dividend payments.

By ensuring that a company’s debt maturity schedule is evenly spread out, dividend investors can mitigate the risk of refinancing issues and ensure a more stable dividend growth profile.

How to Analyse Debt Maturities

Example:

In a company’s 10-K filing, the information related to loans and bonds would typically be presented in the “Notes to the Financial Statements” section under “Long-Term Debt.” Here is an example of how this information could be presented:

Notes to the Financial Statements

Long-Term Debt

The Company’s long-term debt consists of various loans and bond issues, with maturities ranging from 2023 to 2029. The following table summarizes the outstanding loans and bond issues, including their respective maturity dates and amounts:

NB! All figures in millions

The long-term debt is stated at its face value, and interest expenses are recognized on an accrual basis. The Company maintains a debt service fund to ensure the timely payment of principal and interest on its outstanding debt. The Company’s management believes it has adequate resources to meet its debt obligations as they become due.

Although there are many variables when determining what’s a “good” maturity schedule (depending on whether it’s fixed/variable rate debt, recourse/non-recourse etc) but as a rule of thumb I want no more than 20% of debt maturing in any given year.

Conclusion:

As analyzing balance sheets for dividend investing is a crucial skill for investors seeking to invest in companies with a strong dividend growth profile. By understanding key financial ratios such as Debt/EBITDA and Interest Coverage, and the importance of a well-staggered debt maturity schedule, investors can better evaluate a company’s financial health and its ability to sustain and grow dividend payments over time. By applying these concepts to their investment analysis, dividend growth investors can make more informed decisions and build a dividend-focused portfolio that generates stable and growing income over the long term.