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The downside to debt...

Jan 6, 2011

We focus on clean balance sheet while evaluating companies. We often talk about leverage and evaluate the company's risk using the debt-equity and interest coverage ratio. Why so much emphasis on debt?

High aspirations and obsession with growth tempted a number of fast growing companies to take more and more debt to fund expansion and acquisitions. They were so obsessed with growth that most of them failed to understand the increasing risk of leverage on their balance sheet. Resultantly the businesses found it difficult to survive when the crisis hit. This is the reason why we remain wary about debt-laden businesses.

History is full of examples of debt-ridden businesses with survival under question. Such businesses either got sold to new owners or the key assets and properties had to be sold to generate cash. And if nothing worked out the promoter was left with no option but to wind-up. Huge business empires of the size of Enron and WorldCom collapsed because of debt.

Let us now see through recent examples of what happened to aspiring and fast growing companies in India which struggled to service their debt amidst the credit crisis.

Subhiksha, a nationwide retailer of repute, in which ICICI Venture Capital was invested was one of the first victims of the credit crisis and had to face closure of operations.

Vishal Retail is another case in point. Here, the retailer had big aspirations and raised loads of capital to fund its aggressive expansion. It came out with an IPO in 2007 and went on opening new stores in new cities. It did not mind taking huge debt on its balance sheet to fund its aggressive expansion. That was until the recession hit the world in mid 2008. Vishal Retail's aggressive tactics backfired. Unable to service the huge debt that the company had accumulated, it had to finally sell its retail and wholesale businesses to Shriram Group and TPG respectively.

Earlier even the debt-ridden Wockhardt Group had to resort to asset sale to generate enough cash for survival.

Ispat is another company that was on the verge of default lately where the promoters had to sell the stake to JSW Steel.

Leveraged real estate companies also had to take harsh decisions and resort to distressed asset sale to reduce debt. Many real estate companies sold stakes in their key properties and projects or sold the entire plot. Few large projects were abandoned. It has been more than a year since we came out of the economic slowdown. However, the fortunes of most real estate companies are yet to recover. The leveraged balance sheets of these real estate companies continue to haunt them.

The real estate companies today trade close to their historic lows. The price paid for their risk is the substantial erosion in their market value. The markets rose sharply since 2009 but the price for most real estate companies were on the downward spiral and are yet to recover.

These are the reasons why we stress on a debt free / low leverage balance sheet while evaluating companies. High debt has multiple downsides. Growth is certainly necessary for a company. But it should not come at the cost of its survival.

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