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The significance of a strong balance sheet

Jan 5, 2009

The emphasis on earnings growth and the income statement during bull runs is glaring. So much so, that it is enough for many to fail to give a good look at the balance sheet altogether. A scenario of low interest rates, high willingness of lenders to lend and burgeoning demand in the economy is what creates the perfect climate for companies to become greedy and stretch their balance sheets. That's a situation similar to what we have recently witnessed in the period preceding 2008. And it led to similar temptations for many of our Indian companies to stretch themselves to the hilt. The incentive for management to take on excess debt was to expand their corporate empires; to sharply increase capacity or to make big glamorous acquisitions. We need to look no further than our very own Tata group companies like Tata Steel (D/E - 1.6) and Tata Motors (1.34), as also other big companies like Suzlon (1.23), Hindalco (1.9) and Unitech (2.87)*. Brave, maybe, but not a very wise move. We have all witnessed how their stock prices have crashed far below their peers when the tide turned. Shareholders of these companies have got no respite in the last one year.

When times change for the worse suddenly, as they always do, it is the strength in the balance sheet that can mean the difference between life and death for a company. Literally! Like some of the above mentioned, many other Indian companies now find themselves with problems of humungous proportions, and are being forced by the present circumstances to take many unfavorable actions to solve these problems. This, in turn, is causing major wealth destruction for their shareholders.

The problem is that a prolonged period of good growth usually ends up stroking the beast called inflation. When inflation increases, interest rates also increase. At the same time, raw material prices edge higher. Thus, companies try to pass on these costs to customers by increasing the price of their products or services. That, along with higher interest rates cause a sharp fall in demand. Thus companies face a triple whammy. One from higher interest costs. Two, from lower margins. And three from a decline in demand (translating into lower sales for the company). In such scenarios, even the newly made acquisitions go awry as they don't end up delivering the anticipated growth and profits. As they say, all bad things come together.

Such a sudden change in fortunes can beat down the share price of a company mercilessly. Thus it goes without saying that you as an investor, will want to stay away from such a company. A company with a stretched balance sheet is definitely one to avoid, even in the best of times.

In conclusion, a 'stretched' or 'leveraged' balance sheet is like a magnifying glass. It magnifies the good times by providing higher than average returns for the company and lets it do highly ambitious expansion. But at the same time, if things turn for the worse, that too will get magnified. The same companies will then have disproportionately higher problems which can very well lead to insolvency, bankruptcy and ultimately, significant erosion in shareholder value. The lethal aspect of this is the quickness with which things can change for the worse, which can take both management and shareholder by surprise. Thus the caveat for the investor is to always avoid companies with a leveraged/stretched balance sheet.

*As at 31st March, 2008


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