I am preparing a webcast on debt and have been digging around debt covenants and ultimately I wonder if shareholder even know about them never mind fully understand the implications.
When we borrow money in our personal capacity the lender needs to be happy that we can pay it back and as long as we’re making the required payments on time they’re typically happy.
With our listed companies most times the debt will come with a number of additional strings attached, called debt covenants. Examples could be a total level of debt, or EBITDA margins or even just revenue could be a debt covenants. The trick is that if breached the debt can be immediately recalled putting the company under severe strain.
As a rule these debt covenants are not detailed in annual results, but may be referred to if they’re close to be breached as with the recent example of Lonmin. To find the information we need to dig through annual reports and often we’ll need to go back many years for full details from when the debt was first taken out.
Now for the vast majority of listed stocks their debt covenants are not an issue as they’re not anywhere near breaching them. But for a few struggling stocks on the JSE they are a real issue and the bigger picture here is that it is struggling stocks that have the issue. So, tough times can suddenly become a lot tougher and it reminds me of the saying; “how does a company go bust? Slowly at first then suddenly”. A breach of debt covenants can make a tough situation untenable and send the company over the edge and the problem is most shareholders are unaware of the details until it’s too late.
A quick last but important point. Debt is not bad as often this is how a company grows. They borrow money that is put to work generating a higher lasting return, but when things turn south debt becomes a real issue that may require a rights issue or new more onerous terms for the debt.