Latest / How Canadian Markets Work / Episode 75: Leverage and Risk Ratios (The Double Amplifier)

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Episode 75: Leverage and Risk Ratios (The Double Amplifier) · How Canadian Markets Work

0:01
Imagine running a perfectly profitable business.
0:05
Revenues up, margins are steady, your customers
0:08
are happy. Sounds like the dream scenario. Right.
0:11
But then literally overnight, a quarter of your
0:14
net income just vanishes. And you didn't do a
0:17
single thing wrong operationally. I mean, the
0:19
actual cost of your money just changed. Yeah,
0:22
that is a. terrifying reality for a lot of companies.
0:25
It really is. So last time, we looked at short
0:27
-term survival, whether a company can pay its
0:30
immediate bills over the next 12 months. But
0:32
today, we're panning the camera out to long -term
0:34
solvency, the true weight of leverage, and this
0:38
invisible threat of a sudden rate shock. And
0:42
getting to the heart of a corporate collapse,
0:43
it usually starts with people just asking the
0:45
completely wrong question. Oh, how so? Well,
0:48
analysts and armchair investors, they love to
0:50
look at a balance sheet and ask, you know, how
0:52
much debt is too much. Right, like looking for
0:54
a magic number. Exactly. But a massive absolute
0:58
debt load might be perfectly fine for one company
1:00
and then instantly fatal for another. So the
1:03
real question you have to ask is, can they service
1:05
it? More importantly, what happens when the economic
1:09
weather changes? Which makes total sense because
1:11
absolute numbers in a vacuum are kind of meaningless,
1:14
right? So we need to figure out how to actually
1:17
answer that survival question for your portfolio.
1:20
We do. And our mission for this deep dive is
1:22
to unpack the crucial difference between operating
1:25
and financial leverage, expose the hidden traps
1:28
in like those common debt ratios you see on standard
1:31
financial screeners, and then walk you through
1:33
how to stress test a balance sheet yourself.
1:36
before the market does it for you. Yeah and to
1:38
really grasp leverage we have to start by zooming
1:41
out from the balance sheet itself because You
1:44
know, borrowed money is really only one piece
1:46
of the puzzle. Right. The underlying structure
1:48
of a business's costs. That's where leverage
1:50
actually begins. We're talking about operating
1:52
leverage here. Operating leverage. OK. So this
1:55
is the mix of fixed versus variable costs that
1:57
are just built into the business model, right?
2:00
Before a single dollar is ever borrowed. Exactly.
2:03
Let's use a steel mill as an example. OK. Classic
2:05
heavy industry. Right. The plant must run. The
2:08
furnaces have to be kept at this staggering temperature
2:11
24 -7. Union contracts need to be paid, property
2:15
taxes are due. And all of that happens whether
2:18
the mill is operating at 60 % capacity or 90
2:21
% capacity. Precisely. The costs don't just magically
2:24
drop because orders from auto manufacturers slow
2:27
down for a quarter. That sounds incredibly stressful
2:30
to manage. It is. That high baseline of fixed
2:33
costs means the company has high operating leverage.
2:37
But once they sell enough steel to cover that
2:39
massive fixed baseline, almost every new dollar
2:42
of revenue flows straight down to the operating
2:44
profit line. Oh, I see. Because the costs are
2:46
already paid for. Right. It's highly profitable
2:49
on the upside. But I'm guessing that blade cuts
2:51
both ways. It absolutely does. If revenue dips
2:54
even slightly below that baseline, profit doesn't
2:58
just dip a little bit. It completely collapses.
3:01
Because like we said, those massive furnace costs
3:03
and property taxes, they don't budge. Okay, so
3:06
compare that structure to, I don't know, a modern
3:09
management consulting firm. Perfect contrast.
3:11
Their primary costs are just human capital. people.
3:14
Yeah, people. So if the consulting market cools
3:16
off, they can freeze hiring, they can cut bonuses,
3:19
or if they have to reduce headcount relatively
3:21
quickly. So their costs are variable. Exactly.
3:24
Meaning they have low operating leverage, a 10
3:26
% drop in revenue might only mean a roughly 10
3:29
% drop in profit. So a small change in revenue
3:31
for the steel mill produces a massive swing in
3:34
operating profit, but the consulting firm stays
3:36
pretty stable. Right. And that's just layer one.
3:39
The second phase is financial leverage, which
3:41
is the actual debt. The borrowed money. Right,
3:44
because fixed debt obligations, specifically
3:46
the interest payments, they always get paid first.
3:49
So any swing in operating profit causes a massively
3:53
amplified swing in whatever is left over for
3:55
the equity holders. Because the interest expense
3:57
is just another rigid hurdle you have to clear.
4:00
Exactly. When you stack financial leverage, on
4:03
top of operating leverage, you are fundamentally
4:06
changing the risk profile of the entire enterprise.
4:10
I've actually been trying to visualize how these
4:12
two stack, and it feels a lot like a live music
4:16
setup. OK, I like where this is going. So think
4:18
of operating leverage as the volume knob on your
4:22
electric guitar. Sure. And financial leverage
4:25
is plugging that guitar into a massive amplifier
4:28
stack. So if you turn up the guitar's volume,
4:30
it gets loud. Yeah. But if you crank up both
4:34
the guitar and the amplifiers and then you hit
4:36
a wrong note, you don't just get a slightly bad
4:38
sound. You literally blow out the speakers entirely.
4:41
That is a great analogy. And that blown out speaker
4:43
in the business world, that is a corporate default.
4:47
Wow. OK. The most classic recipe for bankruptcy
4:50
is stacking both types of leverage. in the wrong
4:53
environment. You take a highly cyclical business
4:56
with massive fixed costs. Like our hypothetical
4:59
steel mill. Exactly. And you load up the balance
5:01
sheet with heavy debt. Then, when the economic
5:05
cycle turns downwards, the operating leverage
5:08
wipes out the operating profit. And the financial
5:11
leverage dictates they instantly can't cover
5:13
their interest payments. It's an instant death
5:16
spiral. It really is. Which brings us to the
5:18
actual metrics. I mean, if we understand the
5:20
mechanics of the amplifiers, how are we supposed
5:23
to measure them when we're looking at a standard
5:25
10K? Right, because you see these standard ratios
5:27
everywhere. You do. But they seem to have some
5:30
pretty dangerous blind spots. Let's start with
5:33
debt to equity. I mean, on the surface, it's
5:36
just total debt divided by total equity. Seems
5:38
completely foolproof. It does seem foolproof,
5:41
yeah. Until you realize the financial industry
5:43
calculates it in two completely different ways.
5:46
Wait, what? Yeah. And they often do it without
5:48
disclosing which method they're actually using.
5:50
You're kidding. How is that allowed? Well, it's
5:53
just convention. Some analysts and data providers
5:56
calculate it using strictly interest -bearing
5:58
debt. So the actual bank loans, corporate bonds,
6:02
and notes payable. Which makes sense. That's
6:04
the actual borrowed money. But others throw in
6:06
total liabilities. Meaning what? Like everything
6:09
they owe? Everything. Which means they're including
6:12
accounts payable to suppliers. defer taxes, and,
6:16
you know, other operational liabilities that
6:18
don't carry an interest rate and aren't technically
6:20
borrowed capital. But the discrepancy between
6:22
those two numbers could be staggering. It can
6:25
be massive. You might be reading a research report
6:27
using these strict interest -bearing definition,
6:30
and then you go and compare it to a stock screener
6:32
that uses total liabilities. So you're comparing
6:34
apples to hand grenades. Exactly. You end up
6:37
thinking a company is either incredibly conservative
6:40
or dangerously over leveraged based entirely
6:44
on a hidden definition. OK, so if debt to equity
6:47
can be manipulated by accounting interpretations
6:50
like that, it makes sense that lenders want a
6:53
metric based on raw cash generation. They just
6:56
want to see if the bills can actually get paid.
6:58
Right. Cash is king to a lender. Which perfectly
7:00
explains the market's total obsession with debt
7:03
to EBITDA. I mean, you hear about it constantly.
7:06
Lenders use this all the time for loan covenants,
7:09
right? Dictating that a company's debt cannot
7:11
exceed, say, four times its EBITDA. Yeah, lenders
7:14
rely heavily on it because it attempts to approximate
7:16
how many years of current earnings it would take
7:19
to repay the entire debt load. So a debt EBITDA
7:22
of four just implies a four -year payoff period
7:25
if every single cent of earnings went straight
7:28
to the bank. Exactly. And if a company breaches
7:30
that covenant, they hit a cliff. What happens
7:33
at the cliff? The bank can trigger higher interest
7:35
rates, restrict dividend payments, or even demand
7:38
immediate repayment of the loan. OK, but let's
7:41
push back on EBITDA for a second here. By all
7:43
means. We all know it stands for earnings before
7:45
interest, tax, depreciation, and amortization.
7:49
But if we are explicitly ignoring depreciation,
7:53
aren't we just pretending that factories don't
7:55
wear out? Or that servers don't need replacing?
7:58
You've hit a nail on the head. It just feels
7:59
like a convenient fiction for lenders to make
8:02
a cash flow profile look way stronger than it
8:04
really is. Your skepticism is entirely warranted.
8:08
It is a structural bias built directly into the
8:11
metric. By ignoring depreciation, EBITDA makes
8:15
a highly capital -intensive business look like
8:18
this amazing cash printing machine. Because it
8:20
assumes that the historical cost of building
8:23
the factory is somehow irrelevant to current
8:25
cash generation. Exactly. But eventually, that
8:28
steel mill furnace has to be rebuilt. And you
8:31
can't pay the contractor with EBITDA. You have
8:33
to pay them with real cash. Which is why relying
8:35
solely on debt to EBITDA is so dangerous. You
8:38
must always pair it with the capital expenditure
8:40
line from the cash flow. statement right capex
8:42
yeah you need to see the actual cash going out
8:45
the door to maintain those physical assets yeah
8:48
because if maintenance capex is eating up most
8:50
that EBITDA well the company has far less capacity
8:53
to service its debt than the ratio suggests so
8:56
debt to equity is inconsistent and debt to EBITDA
8:58
turns a blind eye to aging equipment correct
9:01
this leads us to the metric that actually cuts
9:03
through the noise interest coverage yes interest
9:06
coverage is beautifully direct you take operating
9:09
income and you divide it by interest expense
9:11
It's just simple division. Very simple. It doesn't
9:14
ask how many years it takes to pay off the principal.
9:17
It asks how many times over the company can pay
9:19
its current interest obligations from its current
9:22
operating profit. It's basically a real -time
9:24
pulse check. Exactly. Okay, let's ground this
9:27
with our running case study. We have Meridian
9:29
Tool Works, our fictional industrial manufacturer
9:32
from the previous deep dive. Let's do it. And
9:34
to avoid just rattling off a dry spreadsheet,
9:37
let's frame their balance sheet kind of like
9:38
a household budget. OK, what else? So they have
9:41
$75 million in equity, but they carry $82 million
9:44
in interest -bearing debt. 12 short -term, 70
9:48
long -term. But if we look at their total liabilities,
9:52
including what they owe everyday suppliers, that
9:55
number jumps to 110 million. OK, so if we apply
9:58
the flawed metrics first, you can instantly see
10:00
the distortion we talked about. Depending on
10:02
whether you use the 82 million or the 110 million
10:04
figure, their debt to equity is either a balanced
10:07
1 .09 or a much heavier 1 .47. Right, apples
10:12
to hang grenades. And looking at their EBITDA,
10:14
which is sitting at 42 million, that's 30 million
10:18
operating income plus 12 million in depreciation,
10:21
their debt to EBITDA is roughly 1 .95x. So less
10:26
than two years of earnings to clear the debt.
10:28
On paper, Meridian looks like an absolute fortress,
10:31
moderate leverage, plenty cash flow. They do
10:34
look like a fortress. And their interest coverage...
10:36
completely confirms that baseline. Okay, walk
10:39
us through the math. Their operating income is
10:41
30 million and their current interest expense
10:43
is 6 million. 30 divided by 6 gives us a coverage
10:47
ratio of 5 .0. So they can pay their interest
10:50
five times over. That sounds incredibly safe.
10:52
It is safe. today. But here is the aha moment
10:55
we really need to dig into. Corporate debt doesn't
10:58
sit frozen in time like a 30 year fixed residential
11:01
mortgage. Right. It matures. It matures. It has
11:04
to be refinanced. And it gets refinanced at whatever
11:06
the prevailing market rate happens to be on that
11:08
exact day. Oh, wow. OK, I see where this is going.
11:11
Think about the massive macroeconomic shift we
11:14
saw between 2022 and 2023. We moved from an era
11:18
of essentially zero interest rates to an incredibly
11:22
aggressive tightening cycle. Right. Companies
11:24
that had borrowed cheaply suddenly face a radically
11:27
different environment when it was time to roll
11:30
over their debt. OK, so let's run that exact
11:32
rate shock on Radian. Let's do it. The business
11:34
itself is operating flawlessly. They are selling
11:37
the exact same volume of tools, margins are identical,
11:41
operating income is still locked in at $30 million,
11:44
but they have to refinance that $82 million in
11:46
debt and rates have jumped. So their annual interest
11:49
expense goes from $6 million to $9 million. So
11:52
their interest coverage ratio drops from 5 .0
11:55
down to 3 .3. Which still seems OK. Still have
11:58
cushion, yeah. The margin of safety is definitely
12:00
shrinking. Now, let's push it to a full stress
12:03
scenario. OK. What if rates have spiked enough
12:05
that their interest expense actually doubles
12:07
from the original $6 million to $12 million?
12:09
OK, so $30 million in operating income divided
12:11
by $12 million in interest, the coverage drops
12:14
to 2 .5. Right. But the real story is the bottom
12:17
line, isn't it? Their pre -tax profit falls from
12:20
$24 million down to $18 million. Their net income
12:23
plummets by a full 25%. Yes. A quarter of the
12:27
shareholders' earnings evaporates solely because
12:30
the cost of capital changed. The business did
12:32
nothing wrong, but the financial leverage amplified
12:36
the rate shock. That is brutal. OK, so a 5x coverage
12:40
is obviously safe, and a 2 .5x coverage hurts,
12:43
but they live to fight another day. Right. What
12:47
is the actual danger zone? What is the threshold
12:49
where analysts start legitimately sounding the
12:51
alarm? Well, the general consensus is that when
12:54
interest coverage drops below 2 .0, the market
12:56
gets very anxious. You're paying half your operating
12:59
profit just to serve as debt. Ouch. OK. Yeah.
13:01
And when it falls below 1 .5, the situation is
13:04
critical. Because there's no wiggle room. Exactly.
13:07
The company has virtually no room for error if
13:09
sales dip even slightly, and if it drops below
13:11
1 .0. Then the operating profit literally cannot
13:14
cover the interest payments. Right. Below 1 .0
13:17
means the business is fundamentally underwater.
13:20
They have to dip into cash reserves, liquidate
13:23
assets, or, ironically, borrow even more money
13:26
just to pay the interest on the money they already
13:29
borrowed. Borrowing to pay interest. That just
13:32
creates a complete death spiral. It does. Which
13:34
is why the most practical thing anyone can do
13:37
when analyzing a company is the DIY stress test.
13:40
Oh, I like the sound of that. How do we do it?
13:42
Don't wait for a quarterly earnings call to find
13:44
out a company is vulnerable. look at the income
13:47
statement, find the interest expense, and just
13:49
mentally double it. Double it just to see what
13:52
happens. Exactly. If doubling the interest expense
13:55
pushes the coverage ratio dangerously close to
13:58
that 1 .5 mark, you know they are highly sensitive
14:00
to monetary policy. That is such a good rule
14:03
of thumb. But to really assess the threat, you
14:05
have to look at the timeline. What do you mean?
14:07
You have to check the footnotes for the debt
14:09
maturity schedule. If they have massive tranches
14:12
of debt coming due in the next 12 months during
14:14
a high -rate environment, well, a refinancing
14:17
shock is imminent. But if the bulk of their debt
14:20
doesn't mature for, say, 8 or 10 years, they
14:23
have the breathing room to just wait out the
14:25
cycle. Okay. And we can't forget the context
14:29
of the business model itself, right? I mean,
14:32
applying a hard rule of 2 .0 to every single
14:34
company kind of ignores the reality of operating
14:37
leverage we talked about earlier. It absolutely
14:39
does. Context is everything. Like, take a regulated
14:42
utility company. They are providing electricity
14:45
with locked -in, highly predictable cash flows.
14:48
They can comfortably carry a massive debt load.
14:50
Because the operating risk is practically zero.
14:53
People pay their electric bills even during a
14:55
recession. Right. But if you take that exact
14:57
same debt load and drop it onto a cyclical mining
15:00
company where revenue can literally evaporate
15:03
overnight if the price of popper crashes, it
15:06
would destroy them. It totally mirrors our previous
15:08
deep dive on short -term liquidity. Oh, how so?
15:11
Well, judging a utility by normal leverage ratios
15:14
is exactly like realizing a grocery store's liquidity
15:17
ratio makes it look bankrupt compared to a software
15:20
company. The industry entirely dictates the reality
15:22
of the math. That is a perfect parallel. Industry
15:25
context is paramount. And beyond industry differences,
15:30
there are significant accounting complexities
15:32
that can really warp these metrics. Like what?
15:35
Take lease obligations. A few years ago, the
15:38
Financial Accounting Standards Board, the FASB,
15:41
fundamentally changed how leases are reported.
15:44
Right, because historically, if an airline leased
15:47
a fleet of jets or a retailer leased 100 storefronts,
15:51
they just recorded the monthly lease payment
15:53
as a standard operating expense. Exactly. The
15:56
massive future obligation wasn't anywhere on
15:59
the balance sheet. It was just invisible. It
16:00
allowed companies to hide billions in effectively
16:03
debt -like obligations. So the rule change forced
16:07
companies to pull the present value of all those
16:09
future lease payments directly onto the balance
16:11
sheet as liability. Which means overnight, without
16:14
a single thing changing in the real world, their
16:16
total liability has just skyrocketed. Yes. Their
16:19
reported leverage ratios artificially ballooned.
16:22
So you really can't reliably compare a pre -transition
16:25
leverage ratio to a post -transition one. Not
16:27
for any company with heavy leasing, no. You also
16:31
have to be extremely vigilant about contingent
16:34
obligations. Why are those? Well, if a parent
16:36
company guarantees the debt of a risky subsidiary,
16:39
That guarantee doesn't usually show up in the
16:42
primary debt figure on the balance sheet. It's
16:44
buried deep in the footnotes. Man, the lesson
16:47
is always read the footnotes. Always read the
16:50
footnotes. And there's one final golden rule
16:53
of leverage ratios that trips up a lot of people.
16:55
OK, lay it on us. Never apply these traditional
16:59
metrics to financial institutions. Really? Never.
17:02
Never. Banks operate as highly leveraged entities
17:05
by design. They take in deposits. which are technically
17:09
liabilities, and they lend them out. Oh, right.
17:12
If you run a standard debt -to -equity test on
17:14
a perfectly healthy regional bank, the math will
17:17
suggest it's on the brink of catastrophic failure.
17:20
They operate under a completely different, highly
17:22
regulated set of capital requirements. Standard
17:25
corporate leverage math simply does not apply
17:27
to them. That makes total sense. Okay, let's
17:30
pull all this together. We've seen how operating
17:33
leverage, which is the fixed costs in a business
17:36
model, stacks with financial leverage, the borrowed
17:39
money, to create this amplifier effect that can
17:42
either supercharge returns or trigger a collapse.
17:46
Right. And we've also established that debt to
17:47
equity is highly vulnerable to different accounting
17:50
interpretations, while debt to EBITDA can dangerously
17:53
obscure the real costs of maintaining depreciating
17:56
assets. Faming the interest coverage ratio, the
17:58
ultimate safety check. operating income divided
18:01
by interest expense. The real -time pulse check.
18:04
Exactly. And the real key is stress testing it
18:07
yourself, right? Projecting a rate shock, checking
18:10
the maturity schedule and the footnotes, and
18:12
contextualizing it all within the specific industry.
18:15
That right there forms a incredibly robust toolkit
18:18
for evaluating long -term solvency. It really
18:20
does. But, you know, there is a fascinating macro
18:23
paradox to mull over based on all of this. Oh,
18:27
yeah. So we just walked through how rising interest
18:29
rates can crush a leveraged company when it's
18:32
forced to refinance. Right. The 25 % drop in
18:35
net income. Exactly. But think back to our earlier
18:37
deep dives on inflation. Inflation actively erodes
18:40
the real value of fixed debt. Ah, yes. Right.
18:43
If the purchasing power of money falls, the actual
18:46
burden of a billion -dollar debt is effectively
18:48
lighter in real terms. It is, which creates an
18:52
incredible tension for corporate treasurers.
18:54
Right. Heavily indebted companies are in this
18:56
bizarre position where they quietly want inflation
18:59
to run hot because it literally melts away the
19:02
real weight of their principle, but simultaneously
19:05
they are locked in this high -stakes tug -of
19:07
-war against central banks who are aggressively
19:09
raising rates to kill that exact same inflation.
19:12
It's a paradox. One force is quietly shrinking
19:15
the real value of their debt while the other
19:18
force threatens to balloon their interest payments
19:20
into completely unsustainable territory. It is
19:23
a silent battle playing out on literally every
19:26
leveraged balance sheet in the market. Does inflation
19:29
melt the debt away before the refinancing cliff
19:31
hits, or does the rate shock crush them first?
19:34
That tug of war is happening right now, and it's
19:36
definitely something to watch closely as you
19:38
navigate your portfolio tomorrow.