Highly geared and financially strong

Include leases at their face value in the notes to the accounts and Next is 5% funded by equity and 95% funded by liabilities of one kind or another.

Most of that ‘debt‘ is the aggregated value of future

payments (rent) on operating leases for stores, which the accounting rules and many investors consider an operating expense not a liability.

However, I find it hard to accept a company’s stores aren’t assets, and the costs associated with financing them liabilities. The most basic definition of a corporate asset is something the company owns, and the most basic definition of a liability is something it owes.

Because it may not be able to afford its leases, rival fashion store French Connection is reportedly considering selling some of those with the highest rents. An alternative might be to sublet the stores. Either way, it’s clear the company owns the right to use the property for the lease term and because it is obliged to pay the leases, unless it can get someone else to buy them or pay the rent in which case it will no longer be able to use them, it has a liability.

A company should be able to pay the rent (or interest, salaries, or any cost) out of profit*. French Connection’s problems stem from the fact that it’s not obvious it can. The balance sheet, particularly if the company has liquid assets like spare cash, acts as a reserve should earnings be insufficient to pay the bills. If that’s unlikely, a company may chose to return spare cash to investors, which is exactly what what Next does, year after year.

The higher debt in relation to tangible assets, and I’ve lumped everything into my measure including sources of finances that are often interest free like money owed to suppliers, the more reliable profits must be to reassure investors the company is still safe.

Other things can help too. For example short-term leases are more readily disposed of, and debt issued as bonds is safer than bank loans because bank loans come with conditions that can trigger insolvency if the company fails to continue to meet them.

Next prefers short-term leases, the size of its borrowings are modest in comparison to them and partly funded by bonds, and here are earnings for the past ten years, years described by Stephen Marks of French Connection, as the most difficult years he’d experienced in retail (he founded the company in 1972):

To calculate rent and interest cover I added operating lease payments back to operating profit and then divided that number by the sum of operating lease payments and interest expense. In other words its operating profit before rent divided by rent and interest expense.

Operating profit (before lease payments) has not fallen below three times rent and interest payments in the last ten years, better than the two times I calculated for JD Sports. The worst year was in 2009, when many people thought the the financial system was collapsing.

Rent and interest cover of three times is another way of saying profits would have to fall to a third of their current level for Next to have trouble paying rent and interest. In fact, 2009 was the only year of contraction in the ten, when operating profit fell 11%.

Provided the business is not changing fundamentally, it  looks as though, despite the gearing, Next is financially strong. That is, at least, what I think management and investors are thinking.

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*When a company gets into trouble cash flow is critical, because earnings are smoothed by assumptions made by accountants intended to produce a more accurate description of the underlying performance of the business. Another remarkable thing about Next though is its strong and consistent cash flow.