ECB action sparks the debt debate

Last week, the ECB stepped up its range of policy instruments to stimulate investment and economic activity across the eurozone.

This included an innovative move to allow the ECB to invest directly in non-financial companies, which suggests borrowings could be available at very low interest costs for a wide range of companies.

The concept will allow the ECB to buy bonds in companies that have investment-grade ratings, which are provided by independent agencies.

These analyse and measure the ability of an individual company to carry debt. With an investment-grade rating, that company can be considered for direct ECB investment for up to 50% of an issue, with the remainder being provided by other financiers.

When official interest rates have moved into negative territory, such a formula should provide long-term debt to companies at interest costs far below those which have prevailed over recent decades.

Equipped with such leverage, companies should be able to support their profit margins and fund investment in plant, equipment, and services that produce economic activity and employment.

That outcome, in turn, is designed to boost economic growth, which is the key objective of any ECB action currently.

The theory behind this package is sound, so now we must wait and see how it works in practice.

Debt is the financial-markets equivalent of nitroglycerine. Before the global financial crisis, it was sold like sweets at a children’s party.

Anyone, whether in a boardroom or their living room, has to think carefully about incurring borrowings.

Low interest rates make debt very appealing, but capital borrowed must still be repaid.

That capital is usually connected to real assets, like houses or companies, and these can be snatched away if capital sums are not repaid according to agreed schedules.

Debt provides a tremendous gearing effect, if managed in the right way.

Take, for example, a business that throws off consistent rates of cash-flow of €100 and represents a 10% return on investment.

Assume, too, the after-tax return is €50, or a 5% return on investment.

If that initial investment was funded by a level of 60% debt and 40% equity, then the business could pay off the debt after six years, by paying €120 per year.

In years one to six, the company is generating an annual return, on equity, of 12.5%, and from year seven the return is 15% — making the original investor very satisfied.

If the entire deal was funded on equity alone, with no debt, the return on equity would be just 6% for the investor, making it less attractive.

You will find investors are constantly toggling the debt and equity percentages to determine an appropriate risk-reward ratio, when assessing projects. At the height of the madness, before 2008, some projects were being surfaced with debt-equity ratios of 80%.

That loaded the potential returns for equity investors, but everything could (and did) go pear-shaped if the expected profits did not materialise.

Using the above example, assume an 80% debt ratio and an annual, €13 interest cost to clear the debt in six years.

Then, assume the cash-flow is squeezed by 50% in a tough economy.

Now, the company has an after-tax loss, the debt providers are screaming, and our equity investor could have its €20 equity wiped out.

In the current environment, I lean towards conservative funding ratios.

Some assets attract long-term, contracted financing, which supports cash-flow models that sustain debt levels above 50% of a project’s cost.

When the income is more variable, and dependent on the economy’s behaviour, the arguments in favour of dialling down the debt are more compelling.

Debt, my mother taught me, is a bad thing. Her sentiment might have been extreme, but her instincts were right.

Debt can accelerate wealth faster than accumulated savings, but it can utterly destroy your business, too.

Joe Gill is director of corporate broking at Goodbody Stockbrokers. His views are personal