Don't let promoters fool you over debt levels! - The 5 Minute WrapUp by Equitymaster
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Don't let promoters fool you over debt levels!

Feb 11, 2011

In this issue:
» Global sovereign debt crisis on the anvil!
» Why MNCs prefer China over India for setting up shop?
» Challenging times ahead for FMCG companies
» RBI warns government over fallout of Middle East crisis
» ...and more!

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00:00
 
Historical debt level is the most inspected item in a company's balance sheet. Especially when an analyst is to judge the company's past track record of settling dues. A trend of high debt to equity ratio in the past indicates the inefficient management of cash flows. A clear signal for investors to avoid taking long term bets on the business. But often the management and promoters of the company make an attempt to make the future look rosier. This is by taking on debt which would be convertible into equity. This would make the equity proportion higher than existing debt making future debt to equity look lower than what it actually is.

We regularly come across such propositions in the sectors with high debt tendency. For example, real estate and textiles. Such adjustments may work well when markets are at a trough and valuations are expected to go much higher. Especially if the promoters take this as an opportunity to buy more into the business. But if the overall fundamentals of the sector do not support higher valuations, the risk of lapse of these convertibles loom large. In such cases the companies are forced to remain stuck with high debt or even repay the same. Chances are that in the absence of adequate free cash flows, these may pose critical risks to the business.

Data source: CMIE Prowess

Thus the perception of risk in high debt levels is notwithstanding the future fortunes of the business. Investors would do well to ignore such businesses which try to camouflage the risk under the guise of being 'temporary'.

Do you think that businesses that have lower debt potential in the future are worth investing into? Let us know your views or post them on our Facebook page.

01:10
 Chart of the day
 
At a time when banks globally are making an attempt to contain employee costs, Indian banks are seeing a different trend altogether. Both the PSU and private sector players are seeing wage bills assuming a larger proportion of overall operating expenses. So much so that the local private sector players are competing with their foreign counterparts in employee cost to expenses ratio! As shown in today's chart, even the PSU banks that have benefitted from large scale retirements in the last decade, have more than half of their operating costs in the form of salaries.

Data source: RBI

01:45
 
There are quite a few thumb rules in equity research. One of the most popular we believe is the debt to equity ratio of a company. It is believed that for a company to be considered safe for investment, the debt to equity ratio should not exceed 1. If these levels are exceeded, the company could have problems repaying its debt in the future. Have you ever wondered whether a similar ratio existed for the optimal debt levels in an economy? It certainly does as per Harvard University economist Kenneth Rogoff.

In a recent interview, Rogoff has argued that many countries in Southern and Eastern Europe have external debt levels that far exceed 60% of GDP. And he believes that historically, that is a high number. In other words, many countries start resisting debt repayment at significantly lower levels. Rogoff has further added that even the US is on an unsustainable path of its own. Thus, in view of this, Rogoff has put forth a view that a global sovereign debt crisis is indeed coming. We cannot help but agree. The mountain of debt that US, Europe and Japan have accumulated does indeed look too big to be repaid anytime in the near future.

02:25
 
'Neighbor's envy but owner's pride'. We are referring to China's execution capabilities that are now becoming India's envy. In an interview to a leading daily, Genpact has stated that setting up business in China is much easier than setting up shop in India. The reason for this is China's excellent execution capabilities.

The Chinese art of execution and planning capabilities are excellent. So much so that companies like Genpact can actually start operations within 3 months. India has the best technologies but woefully lags behind when it comes to the execution of these. The country's poor infrastructure and logistics hamper their capabilities. No wonder then that most multi-national companies now prefer China over India for setting up shop. The only hitch is that the Chinese government has pretty stringent rules when it comes to setting up foreign businesses. But they are streamlining these already. If India wants to continue being an attractive investment destination, then it will have to pull up its socks and improve its capabilities. It can always take lessons from its capable neighbor.

03:05
 
The Indian government has set some ambitious goals. It targets about US $120 bn engineering exports by 2015. This means triple the current quantum of engineering exports. Currently, in the engineering space we are one of the fastest growing exports. While the global average is around 13%, we are growing at nearly 30%. In the current financial year, the US $50 bn mark is expected to be achieved.

In FY10, the US and EU accounted for about 65% of the shipments. However, exporters are exploring new destinations in regions like South-East Asia and Latin America. This will reduce dependence on traditional markets like the US and Europe.

We think this will surely boost the manufacturing sector. But the lofty targets cannot be achieved unless government policies are positively aligned.

03:30
 
In a scenario where India's inflation still remains high, the ongoing crisis in Egypt has given India a lot to worry about. Indeed, the RBI governor has stated that the Indian government will have to prepare for the implications of a prolonged crisis in the Middle East which will fire up oil prices. The government for its part is in a quandary. Obviously, it is not in favour of raising prices of diesel, kerosene and LPG. Simply because this would push up an already high inflation higher. But the alternative of subsidizing prices will only inflate the government's overall subsidy bill. Plus stretch its already deteriorating balance sheet.

The RBI for its part has been raising interest rates to bring inflation under control. But the governor has stated that some fiscal consolidation is in order. For that, the government will have to come out with a credible plan for the near and medium term. Readers would do well to recall that in the last Budget, the government unveiled a roadmap for fiscal consolidation until FY13. Whether it is able to stick to meet the targets outlined in this plan remains to be seen though.

04:10
 
The coming quarters are likely to be challenging for FMCG companies. Commodity inflation is taking a heavy toll on their profitability. So much so that during the last quarter, gross margins fell by 2-5% for the sector. So far, strong volume growth has been able to sustain the bottom lines for these companies. But we feel it is only a matter of time before inflation forces consumers to either cut back on allied expenditure or downtrade. This would result in slower bottom line growth as both volumes and realizations come under pressure.

04:30
 
After languishing in the red for most part of today's session, the Indian indices managed to cross the dotted line in the latter half of the session today. The BSE Sensex was trading around 176 points higher at the time of writing this. The mid and small cap indices were up 2.2% each. The Indian stock markets were amongst the few gainers in Asia. The European markets have opened a mixed bag.

04:45
 Today's investing mantra
"I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going." - Peter Lynch

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2 Responses to "Don't let promoters fool you over debt levels!"

sid

Feb 11, 2011

Why are Indian markets so dependent on FIIs! :[]

Bring all Indian money from foreign illegal bank accounts and India will not be dependent on others!

Like your article "The day I attended my own funeral". But I think Mr. Manmohan Singh is a gentleman, a great economist. He is not free to do much as he is controlled by Sonia & co.

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M. Srinivasa Rao

Feb 11, 2011

Lower debt is one of the most important parameter I look inot before investing. Companies lower debt can withstand when margins are under pressure.

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