We penalise companies with a high and rising level of cash interest expenses relative to cash from operations (CFO, otherwise known as operating cash flow) relative to industry peers. The higher interest expenses are relative to CFO, the lower a company’s level of solvency. This method is good at highlighting companies where reported profit is not backed-up by operating cash inflows and may have difficulty in servicing debt. Globally, interest expenses account for just 7% of CFO although there is some variance by industry. For example, asset heavy sectors, such as REITs and Electric Utilities, bear substantially higher levels of interest expense, presumably because of less volatile cash flows.
Under our accounting screen a red flag is triggered when interest expenses/CFO exceeds the 80th percentile relative to industry peers (i.e. it is very high). A red flag is also triggered when interest expenses/CFO rises at an unusually large rate over 1 and 3 years. Again, this is when the increase exceeds the 80th percentile relative to industry peers between 2010 and 2015.