Must-know: Leverage—why the ratios look better today
Why leverage is a key value driver for ArcelorMittal
The steel industry is capital intensive. Companies have to invest huge sums of money in plants and machinery. Leverage is a key indicator for investors to watch. Huge amounts of debt increase the interest burden on a company and the riskiness of the stock. If the risk isn’t fully justified by the expected return, the share price gets punished by the market.
Leverage ratios remain a key indicator impacting profitability of ArcelorMittal (MT) and other steelmakers like United States Steel Corporation (X), Nucor Corporation (NUE), and Reliance Steel & Aluminum (RS). It also affects the returns for exchange-traded funds (or ETF’s) like the SPDR S&P Metals and Mining ETF (XME).
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What are the key indicators for analyzing leverage?
We look at the following indicators for analyzing the leverage for the stock:
- Net debt – Net debt is the measure of total debt, which a company has taken adjusted for any cash that it holds. For ArcelorMittal this figure has decreased as the company has been rationalizing its operations and repaying some of its outstanding debt.
- Net Debt to EBITDA – A company’s debt shouldn’t be looked at in isolation. We look at a relative ratio, like net debt to earnings before interest, taxes, depreciation, and amortization (or EBITDA). The basic reasoning is if the company takes more debt, its earnings growth should increase to support the debt payments. For ArcelorMittal this figure has actually gone up since 2007. This is a reflection of the declining profitability of the company.
- Average debt maturity – Average debt maturity is an indicator for the maturity profiles for various debts which are outstanding for the company. For a company that has to invest massively in capital requirements, the maturity profile should be higher to match the higher gestation period of the projects it invests in. For ArcelorMittal the average maturity has increased from 2.6 years in 2008 to 5.9 currently. It’s a welcome sign because the company doesn’t get impacted by short-term interest rate movements.
- Structure of liabilities – There are a lot of avenues for a company to fund its liabilities. The major ones are bank funding, issuance of bonds, and convertible securities. In bank funding, there are some restrictions placed on a borrower through debt covenants. A debt covenant is like a contract between the bank and the company. It has often had restrictions on dividends and the use of funds or charge on assets. ArcelorMittal has reduced its reliance on bank financing over the years. Today this component makes up 10% of the total debt as compared to 84% in 2008.