Risk Management

Leverage Ratios Surge at Large Companies

More than 350 U.S. firms now have a thinner earnings cushion to cover the debt on their balance sheets.
Vincent RyanApril 10, 2013

Low interest rates are still enticing companies to borrow. Commercial and industrial lending increased 11 percent in 2012 and nearly 13 percent in January, according to the Federal Reserve, and C&I rate spreads over federal funds were still very low in the first quarter, 2.83 percent. But are some companies overdoing it?

Businesses are not just refinancing. In the last year, large companies have altered their capital structures, some drastically, by increasing the amount of debt they are willing to put on their businesses. That could eventually cause banks to deny them additional credit or require more concessions when revising credit agreements.

Indeed, some U.S. firms have piled on so much debt that they have less margin for error if their earnings go south or if interest on floating-rate debt starts to rise.

An analysis of data provided to CFO by S&P Capital IQ shows that 369 large U.S. companies (more than $500 million in revenue and $250 million in EBITDA) increased their net debt-to-EBITDA ratios in 2012, about 10 percent of the total number of firms in that size category. The median company increased net debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) to a ratio of 2.43.

The ratios themselves are not alarmingly high. (See chart below.) Bank covenants usually stipulate debt-to-EBITDA ratio can’t go above 5, which only two companies in the top 25 surpassed. But many of these companies might find it harder than it at first seems to meet their debt obligations out of their earnings.

Net debt subtracts cash and cash equivalents from long and short-term borrowing. So a net debt-to-EBITDA ratio increase can mean different things – that the company’s EBITDA fell year-over-year, for example, that its cash balances shrunk, or that it added a large amount of new debt. Among the universe of 369 companies, the last reason was overwhelmingly the most common. The median increase in total debt was 18 percent, compared with a median rise in EBITDA of just 2 percent.

The chart shows the companies whose net debt-to-EBITDA rose the most in calendar year 2012, but the one-year trend of ballooning leverage doesn’t mean the same thing for all of these companies. At the top of the list, for example, household and personal care products maker Church & Dwight issued a $400 million bond to help finance a $720 purchase of Avid Health, a nutritional supplement company. Church & Dwight is paying an interest rate of 2.875 percent and the bond doesn’t mature until 2022.

But for other companies on the list, higher net debt to earnings is alarming. Kraft Foods Group, a new spinoff, is being capitalized with $10 billion of debt. But, as research firm Gimme Credit pointed out last year, the prospects for the business “are not all that rosy.” In particular, revenue in the unit declined 1.7 percent last year and profit margins are also falling, all in a very mature product market. In addition, “KFG’s leverage will be virtually higher than all its peers,” Gimme Credit said in its report.

Micron Technology,  meanwhile, had a 41 percent drop in EBITDA last year and is facing tough conditions in the semiconductor market as a decline in personal-computer sales hurts its legacy memory-products business.

Industrial products company Colfax paid down some debt last year and had a big jump in EBITDA. But Moody’s Investors Service slapped a negative outlook on its revolver and term loan last month.

”Though the company’s interest expense will decline due to recent refinancing and its leverage metrics will benefit from the $200 million debt paydown, the company’s leverage still remains elevated in Moody’s view and the general outlook for its business remains challenging particularly given the weak European economies,” Moody’s said in a rating action report.

Companies are not only borrowing more, but changing their financial policies on leverage. That may boost returns on equity, especially as long as interest rates remain low. Without continued earnings growth, increased profit margins, or substantial efficiency gains, however, these debt loads may eventually have to be reduced.