Analytical Review 101 – Part X

LOANS AND BORROWINGS

Financing Company's Operations
To set-up a company, the shareholders need to initially pump in cash to finance the operations of the company. This is usually represented by the share capital.

Why Borrow?
Even though the operations of the company may be highly profitable, sometimes the shareholders are unable to expand as they have insufficient cash to finance costly expansions such as building new factories or investing in more sophisticated machineries or R&D. To finance such expansions, companies often borrow from banks or leasing companies.

Loans
Borrowings from banks usually come in the form of loans. If the company is small one, some form of security is required, either on the assets of the company such as land & buildings or personal guarantees from directors of the company. For large companies with excellent credit ratings, the banks may offer an unsecured loan.

Finance Lease Liabilities
Financing from leasing companies are in the form of purchase of large assets such as plant and machineries. The leasing companies will pay the suppliers of such machineries. The company will then undertake to pay the leasing companies a fixed monthly lease payment over a period of time. The total monthly lease payments will exceed the purchase price of the plant and machineries. These lease commitments are recognized in the Balance Sheet as Finance Lease Liabilities.

Operating Cash Flows
Banks and leasing companies are not charities. They expect the company to repay the monthly installment payments comprising of the principal and interest on a timely basis. A company that has loans and borrowings, must generate sufficient positive operating cash flows to finance the monthly installment payments. The Operating Cash to Loans and Borrowings Ratio (OCLB) indicates the financial ability of the company to repay such loans. A ratio higher than 1.5 is a positive indicator of the company’s abilities to service its’ loans and borrowings.

Interest Rates and Gearing
A benefit of loans and borrowings is that the interest’ rates charged by banks and leasing companies are usually lower than the profits generated by companies.

For example, if the company can generate profits of 15% on every Ringit invested in the Company, whereas the effective interest on loans is only approximately 5%, it may be desirable to borrow money to finance expansions. Why? Instead of raising additional share capital from its’ shareholders, the company can borrow from the banks instead. The banks are only entitled to a 5% return on its’ loans. The shareholders will be entitled to pocket the excess 10% difference (15% profit – 5% interest).

The effective interest rates on loans and borrowings can be computed as indicated above. When the company is generating a return that is substantially in excess of the effective interest rates, this is reasonably good as the shareholders will enjoy a higher return at the expense of the banks and leasing companies. Further, the interest payments to the banks or leasing companies are tax deductible, which will further reduce the company's tax expense.

In financial terms, this benefit is known as gearing or leverage.

The Dangers
Often companies tend to leverage their Balance Sheets excessively. Whilst using Other People’s Money (OPM) is an enticing idea, there are dangers if taken to the extreme. These include:

1. Downturn in economy or industry
When there is an unexpected downturn in the economy or the industry, the company’s operating cash flows will quickly dry up. Without sufficient operating cash flows, the company must resort to using its’ cash balances to repay the banks and leasing companies. If the company is unable to manage its’ cash flows well or refinance its’ loans, it may fail to service its’ debts. This may result in the banks or leasing companies foreclose on the loans and file a bankruptcy suit against the company.

2. Non-viable Business Model
If a company is perpetually refinancing its’ loans with and the quantum of loans and borrowings on its’ Balance Sheet is ballooning, this may indicate that the business model is not a viable one. Remember, a company’s PRIMARY PURPOSE is to generate PROFITS and convert them into CASH! When a company is unable to generate sufficient operating cash flows to repay its' loans and borrowings over the long term, you must ask yourself this:

IF NOT NOW (the company can't repay its' loans after a no. of years), THEN WHEN (can the company generate sufficient cash to do so)?

Analytical Review
A cursory review of the effective interest rates indicates that Nestlé is managing to keep its’ borrowings costs extremely low. An effective interest rate of only 4.70% (2006: 5.80%) is extremely favorable as the current FD rates per annum are approximately 3.70%. Further, all the borrowings of the company is unsecured which reflects the company has excellent credit ratings.

The OCLB ratio is 2.52x (2006: 1.35x) reflecting that Nestlé will have little trouble servicing its’ debts. Overall, with such strong operating cash flows, the burning question is WHY BORROW in the first place?

There may be two main reasons for this. Firstly, Nestlé wishes to leverage its’ Balance Sheets to generate higher returns for its’ shareholders. Secondly, it may be using these borrowings to maintain its’ aggressive dividend payout policy to maintain its’ share prices.

Even though RM308MIL of loans and borrowings are due in 2009, Nestlé strong operating cash flows and excellent credit rating, means the company will no problems in refinancing such loans.

Conclusion:
Despite having huge loans and borrowings of RM308MIL and amounts due to related companies of RM129MIL, Nestlé is financially stable. Its’ operating cash flows are sufficient to enable it to repay these borrowings in the long term.