Investing in bonds is like loaning your money to the big corporations who promise to pay you a certain interest every year for a number of years. Once the term is over, the corporation will return the principal to you.
Investing in bonds is generally safer than investing in stocks because your capital is preserved until maturity, while you receive regular income. While it is less risky to invest in bonds, it doesn’t mean that it is completely a safe investment.
There is a risk that the company that borrowed money from you may default due to bankruptcy or cash flow problems.
Unlike banks that foreclose your collateral properties when you fail to settle your loan, there is nothing to foreclose from the companies when they fail to pay you because the money that you lend to them is not secured by any collateral asset.
So it is important that in order to lower your risk, you need to choose carefully the company that you want to entrust your money to.
How do you know which bond is safer? Here are the five things that you need to check from the borrowers’ financials before you decide to loan your money to them:
1. Know how efficient the company is in generating profits
Before you invest in a company, it is important that you understand how the company derives its earnings. You need to know how profitable the company is because this is where the company will derive its cash flows to pay its debt.
There are many ways to assess a company’s ability to generate earnings. It can be by looking at operating margins that show how the company is able to translate sales into profits or by measuring how much returns the company gives to shareholders.
SM Prime Holdings recently offered seven-year fixed rate bonds at 5.1683 percent per year. By reviewing its financial profitability, you can see that the company registered a higher return on equity of 11 percent in 2016 compared to 10 percent the previous year. Net profit margin, on the hand, was a healthy 30 percent last year.
By knowing how profitable the company is, you will know more or less that it will have enough resources to pay off its loans.
2. Know how the company’s earnings can cover its interest expenses
No matter how much interest income the company promises to pay you, if the business is not generating enough cash flows from earnings, there is a good chance that the company may miss some interest payments to you and it’s possible you may not be able to get back your capital on time.
When you review the financials of the company, look for the operating cash earnings and compare this with its current interest expenses. You can compute the cash earnings by adding back non-cash expenses such as depreciation and amortization expenses to operating income. Once you get this figure, divide this by the amount of interest expenses to get your ratio. An interest coverage ratio of two or higher is generally considered satisfactory.
Ayala Land recently offered bonds that pay 5.26 percent per annum for 10 years. The interest coverage ratios of Ayala for the last three years will show that it has sufficient cash earnings to cover its interest expenses. Ayala’s ratio has been increasing from 5.7x in 2014 to 5.9x in 2016, which is way above the minimum benchmark of 2x.
3. Know how the company’s cash flows can cover its total debt
When you deduct portions of cash earnings to finance inventories and accounts receivable or any working capital items, what’s left is called operating cash flows. You need to know how many times the company can cover its total interest-bearing debt by its operating cash flows. The higher the percentage ratio, the better the ability of the company to handle its total.
Aboitiz Power is in the business of power generation and distribution. Early this year, it offered 10-year fixed rate bonds that pay 5.3367 percent per year. It generated operating cash flows of Php29 billion in 2016, higher than Php25 billion the previous year. To compute for the cash flow to debt ratio, simply divide its existing debt of Php160 billion to give a ratio of 5.4x.
4. Know how much of the company’s assets is financed by debt
Too much debt can signal possibility that the company may not be able to earn enough to pay its interest expenses. When a highly leveraged business encounters an unstable economic environment, revenues can suddenly become volatile and increase the risk that operating income may fail to cover the annual fixed interest charges.
In order to evaluate a company’s capital structure, compute for the company’s debt to equity ratio. A ratio of 2.0 and above in general makes a company financially risky.
DoubleDragon Properties, which successfully raised Php9.7 billion from offering seven-year bonds that pay annual interest of 6.0952 percent, has a debt-to-equity ratio of 1.06x as of March 2017. This makes the company financially healthy with a balanced financing of debt and equity.
5. Know the ability of the company to pay short-term debts and payables
The company may have a lot of assets to support the business but if it is not liquid enough to pay off its short-term liabilities, it may soon have cash flow problems. Soon, if it fails to support its day-to-day operations, it will eventually become insolvent and technically bankrupt.
It is important that the company must have more total current assets than current liabilities to be considered liquid. You can measure the liquidity position of the company by dividing the current assets with current liabilities to get current ratio. A ratio of more than one means that the company has more assets than liabilities so that the higher the ratio, the better.
Megaworld Properties, which offered seven-year fixed rate bonds this year at 5.3535 percent interest, has a current ratio of 3.27x. This means that the company has more than three times worth of current assets than its current liabilities, making it a highly solvent company.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice email@example.com or follow him on Twitter @henryong888