Using borrowed capital (“leverage”)

Over the years, we have received many questions from investors and other capital market players about the use of leverage and the potential risk of group leverage. The use of leverage is a natural, healthy and advisable element for any company of any size. The stronger the company, the more leverage it has access to, and the cheaper it is. Companies such as Apple or Berkshire Hathaway, which hold significant cash resources, have bond issues in all global financial markets.

Also, using leverage brings higher returns to shareholders, as long as the interest rate paid is lower than the return on money over a comparable period. For example, if a company borrows capital at an interest rate of 10% per annum, and uses it to buy goods and place them with customers at a mark-up of 5%, collect the invoice from the customer and then repeat the cycle 5 times in a year (a total rotation of 6 times), this generates a return on money of 30%, while the cost of money is only 10%. In this example we have illustrated how to correctly compare the cost of money (which is expressed as an annual cost) with the gross margin generated by placing money in a business (which must be brought to the common denominator – annualised by multiplying by the customer turnover rate).

This calculation should be done to compare relevant percentages. Our recommendation is not to compare the annualised interest rate with the operating return of a business – also expressed as a percentage, without taking into account the different sizes to which these percentages apply. Interest is applied to the amount borrowed, and a business’s operating return is calculated as the ratio between the operating profit (or EBITDA or free cash flow) and the turnover. The only case in which the comparison of the two percentages (interest and EBITDA percentage) is relevant is if the amount borrowed equals the turnover. This case is, in our opinion, not encountered in practice.

Therefore, a company can borrow RON 10 million, over a 5-year period, at an interest rate of 10% per annum to buy a company that produces RON 3 million of EBITDA (or cash flow), at a turnover of RON 100 million (an EBITDA percentage of 3%). Such a scenario is also profitable for the creditors who lend the company, who receive an annual interest of RON 1 million and the RON 10 million back at maturity, but also for the debtor, who keeps in perpetuity an asset that “paid for itself” and has a market value at the end.

Please keep in mind that in this scenario the company made zero cash effort: considering that in the 5 years the purchased asset (the target company) produced RON 15 million in cash (5 years x 3 million), which is equal to the total amount paid to creditors. Although the company borrowed 10% to buy something that produces only 3%, the fact that the company did not cost an amount equal to the turnover means that the easy comparison (10% vs 3%) does not provide any useful information, but on the contrary, it conceals the fact that the whole project is fair and profitable.

In the above scenario we have assumed that the extra cash amounting to 2 million produced by the target company annually against the interest payable IS NOT INVESTED in any way and brings no other return to our group! This assumption is not rational and it is much more relevant to apply to these amounts the approximately 50% return on equity that I have already illustrated in the calculations, to understand that we actually gain cash, equity and assets when we acquire a 3% EBITDA company using 10% interest bonds.

At the same time, some investors have told us that for them it is net profit that counts, and using borrowed capital means that once interest is paid, net profit decreases or even becomes negative, starting from a positive operating profit and cash flow. In this regard, we present the example of Liberty Global (formerly TCI), a business managed by Jim Malone and one of the most successful investment stories ever. The strategy of this company was based on the continuous acquisition of companies using borrowed capital and generating enough EBITDA to cover debt service, in order to be able to continuously expand the borrowed capital. It is also important to bear in mind that, unlike retail investors, banks and investment funds use adjusted EBITDA or FCF as indicators they take into account when evaluating investment opportunities.