There are entire textbooks dedicated to balance sheet management and capital structure theories. Luckily, you don’t need to understand the intricate details of securitisation or treasury strategies. If nothing else, you just need to understand what happens when bad balance sheets happen to good people.
The word "leverage" has been hijacked by the MBA-types and watered down through overuse. It’s been a more enjoyable experience holding gold shares this year than reading yet another sentence that starts with: "We will leverage our capabilities in …"
If you’ve looked at a 2021 share price chart for AngloGold, for example, you’ll fully understand that analogy. Gold has been on a wild ride that has only recently started to come right.
As in science, the concept of leverage simply refers to a force being applied on one end producing a greater force on the other. In finance, the input is either revenue or equity, depending on whether we are considering operating or financial leverage.
Ever heard someone say that the next sale "drops straight to the bottom line"? This means that there are low variable costs, or that the unit economics are highly attractive.
These are phrases you would have heard before, best explained by the example of an airline.
The cost of filling one more seat on a plane is very low. The pilot needs to be there whether there are 10 passengers or 100 adults and their children. Though the weight does make a difference to fuel usage and carries a small variable cost, the value of an extra ticket is almost pure profit.
The same is true for schools. There is almost no variable cost whatsoever to having an extra child in a class at your local private school. The teacher still gets paid the same paltry salary and the lights still need to be on all day. There is a substantial fixed cost base once the schools are built, which means the likes of Curro print cash if they can fill the schools, but perform poorly if enrolments drop below a certain level.
Companies with a higher proportion of fixed costs to variable costs thus have more operating leverage. This is great in the good times, as profit growth can exceed revenue growth. In troubled times, the reverse is true; profitability can disappear if revenue drops by just 10%-20%. We saw this theme play out in 2020 as companies embarked on extensive cost-cutting projects in response to a drop in revenue.
It all comes down to risk or reward, just like everything else in finance. Having mainly fixed costs is risky, but it’s exceptionally profitable when utilisation rates are high. Just look at Grindrod Shipping and the mining industry as perfect current examples.
The other type of leverage that can either make investors rich or put a business into an early grave is financial leverage, which is the level of debt on the balance sheet relative to equity (or to assets; it doesn’t matter which way you look at it, as the equity and liabilities section of the balance sheet simply tells you how the assets are funded).
The cost of debt is always lower than the cost of equity. In other words, companies can borrow money from the bank at a cheaper rate than the returns demanded by shareholders. If you’ve ever wondered why a company might raise debt and do share buybacks in the same period, it’s because that company is actively managing its funding mix in an attempt to maximise return on equity. In doing so, significant share price growth through a rerating of the multiple can be achieved. Less debt isn’t always better.
Sometimes companies fly too close to the sun and employ a mix of operating and financial leverage that creates a recipe for disaster.
When things get tough, a company with a thick slice of equity on the balance sheet can take the punches and survive through the cycle. A company with risky operations and high levels of debt is a ticking time bomb.
Will we see more capital raises in the hospitality sector? With the latest revolting news of SA being shut out from the world, it’s heartbreaking to consider what the future might be of our local hotels.
Listed groups like City Lodge have significant operating leverage and plenty of debt as well. The combined risk is significant, especially when the most important month of the year for tourism looks set to be ruined once again.
For investors, the risk of an indebted balance sheet combined with high operating leverage is that the banks may end up holding the keys to the castle. Debt covenants can force equity capital raises, as we’ve seen in Tongaat and in Brait.
I suspect that more capital raises by JSE-listed companies are coming.
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