This blog builds upon an initial post by Financial Jungle about income trusts. Financial Jungle and Million Dollar Journey and I have agreed to cross-blog on this topic this week. Here is Financial Jungle’s post on business trusts and MDJ’s post on REITs. As an investing structure designed to pay out steady cash to investors, an income trust is ideal for people who require cash flow greater than capital appreciation. But, herein, also lies the problem. An income trust is one of the few investment vehicles where the investor may be conditioned to look at the distribution more than the profitability of the company.

As a result, some investors may end up focusing on short term goals (i.e. distribution) over long term goals (i.e. will the company be around long enough to pay out distribution year over year). Finding a good income trust is a balancing act between seeking superior cash distributions and the sustainability of such distributions.

Typically, this requires an analysis on the following financial factors:

1. What is the payout ratio of the income trust? This is calculated by cash distributions (which is found in quarterly financial statements) divided by distributable cash (the amount of money available for distribution after expenses found in press releases or quarterly reports). A desirable payout ratio varies from trust to trust; some trusts require repeated capital investments and have lower payout ratios to keep cash around while others have fewer capital replacement needs and can pay out larger distributions. However, a ratio close to 100% is not desirable since there is little financial flexibility to invest in new equipment/land without cutting the cash distribution. If the ratio is over 100%, the income trust is paying out more cash than it has and it is in a negative cash flow position after every distribution. Over time, the distribution will have to be reduced or the income trust simply runs out of cash.

2. Is the income trust in a negative cash flow position? This was previously mentioned by Financial Jungle. If the cash distributions are greater than the sum of cash from operating activities, funds from operations and other cash flow items then the income trust is, again, in a negative cash flow position after paying out its cash distributions and the distribution will be reduced some time in the future.

3. Is the income trust incurring a lot of debt? An income trust needs cash to make distributions. Thus, if its debt begins to increase quite dramatically, it will be hard pressed to pay its distributions given the obligations it has to its lenders. Look at the debt to capital ratio (sometimes summarized for you; other times, you will have to do the calculation yourself). Debt to capital ratio is calculated as debt divided by (shareholder equity + debt). The higher the ratio, the more the income trust is in debt and the greater the danger it cannot maintain its distribution. A company with too much leverage also tends to increase its risk of loan default (does not strictly apply to banks though). Watch for a sudden jump in the ratio- it is not a good sign for the distribution or the income trust.

4. Is the income trust maintaining its capital assets? This is a harder item to find- Al Rosen has written extensively on how this can be hidden using accounting tricks. If the income trust is not replacing capital assets (equipment/land) because it is using all the free cash towards paying cash distributions, it has no long term focus. Eventually, all the capital assets will need to be replaced and a trust who has made little investment in its equipment will be hard pressed to replace equipment without slashing its distribution.

5. Is the income trust issuing a lot of new shares? If shares are continuously being issued, and the payout ratio is high, this may be a troublesome sign. It could mean that new shareholder equity is being used to pay the cash distributions. In many senses, the income trust has become nothing more than a pyramid scheme. Look at the number of shares issued and outstanding from time to time; if it is increasing (assuming no share splits) year over year and the proceeds of the shares are not being used to purchase new equipment or finance an acquisition of a competitor, the trust may be robbing Peter to pay Paul.

These are 5 financial factors that anyone should look at before they invest in an income trust; there are other financial factors but I am summarized the more common ones. One thing to note however- there are currently no consistent and enforced accounting practices for income trusts so the amount of financial disclosure a trust undertakes is also an important factor. Look to Million Dollar Journey and Financial Jungle’s posts on industry particular characteristics of different types of income trusts. Hope you enjoy their posts.