Look at the Covenants
Covenants are provisions banks attach to long-term debt that trigger technical default when violated by the borrowing company. Such a default will lower the credit rating, increase the interest (cost of borrowing), and often send the stock lower. Bond covenants include but are not limited to the following:
- Limits on further issuance of new debt.
- Limits, restrictions, or conditions on new capital investments or acquisitions.
- Limits on payment of dividends. For example, it is common for a bond covenant to require that no dividends are paid.
- Maintenance of certain ratios. For example, the most common bond covenant is probably a requirement that the company maintain a minimum ‘fixed charge coverage ratio’. This ratio is some measure of operating (or free) cash flow divided by the recurring interest charges
Assess Interest Rate Exposure
Two things complicate the attempt to estimate a company’s interest rate exposure. One, companies are increasingly using hedge instruments, which are difficult to analyze.
Second, many companies are operationally sensitive to interest rates. In other words, their operating profits may be indirectly sensitive to interest rate changes. Obvious sectors here include housing and banks. But consider an oil/energy company that carries a lot of variable-rate debt. Financially, this kind of company is exposed to higher interest rates. But at the same time, the company may tend to outperform in higher-rate environments by benefiting from the inflation and economic strength that tends to accompany higher rates. In this case, the variable-rate exposure is effectively hedged by the operational exposure. Unless interest rate exposure is deliberately sought, such natural hedges are beneficial because they reduce risk.
Fixed-rate debt is typically presented separately from variable-rate debt. In the prior year (2002), less than 20% of the company’s long-term debt was held in variable-rate bonds. In the current year, Mandalay carried almost $1.5 billion of variable-rate debt ($995 million of variable-rate long-term debt and $500 million of a “pay floating” interest rate swap) out of $3.5 billion in total (leaving $2 billion in fixed-rate debt).
Don’t be confused by the interest rate swap: it simply means that the company has a fixed-rate bond and “swaps” it for a variable-rate bond with a third party by means of an agreement. The term ‘pay floating’ means the company ends up paying a variable rate; a ‘pay fixed interest rate’ swap is one in which the company trades a variable-rate bond for a fixed-rate bond.
Therefore, in 2003, the proportion of Mandalay’s debt that was exposed to interest rate hikes increased from 18% to more than 40%.
Taken From : Advanced Financial Statements Analysis