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Should one always ignore high debt companies?

Jul 6, 2012

The financial crisis that occurred a few years ago made a lot of investors wary of companies with high debt levels. This, because the uncertain future made it difficult for them to ascertain whether such companies would be able to service the debts.

In fact, we believe this should hold true for all times and not only periods of uncertainty. However, does this mean that one should stay away from all high debt companies (those having a debt to equity ratio in excess of 1)?

Well, we do not entirely believe so. While there are many factors that should be kept in mind, we will touch upon a few of them.

First and foremost, the 'Return on Capital Employed' (ROCE) of the company is one factor that should be gauged at.

Capital employed in simple terms is the value of all assets employed in a business. It can be calculated in two ways - from the 'Application of funds' side and the 'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan funds.

ROCE is calculated by using the earnings before interest and tax (EBIT) and the capital employed. As such,

ROCE = EBIT/ Capital employed * 100

This ratio helps in assessing the returns that a company realises from the capital employed by it. In other words, it represents the efficiency with which capital is being utilized to generate revenue.

What this ratio is essentially showing is where a company is able to garner returns in excess of its cost of capital (or debt in this case). For example, why would one want to invest in a company having high debt with interest costs of above 10%, while its ROCE is less than 8%? As such, the key factor remains whether a company is able to earn returns in excess of the cost of capital. If that is the case, it should be viewed as a positive.

Secondly, investors would do well to keep in mind the company's interest coverage ratio.

This ratio helps in gauging how comfortable a company is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. As such,

Interest coverage ratio = EBIT/ Interest expense

For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20 m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m).

While one can say that the higher the ratio, the lower are the risks in terms of a company defaulting towards paying the interest costs, but one could say that an interest coverage ratio of about three times could be considered safe.

We thought it would be good to list out a few companies that satisfy both of the above criteria. The list is of stocks forming part of the BSE-500 Index. What we first did is removed banking and financial companies from the list and then removed companies having a five-year average debt to equity ratio of less than 1. We then, excluded the companies whose 5-year average ROCEs were less than 15% and 5-year average interest coverage ratios were lower than 3 times. At the end we finalized our list by sorting the data based on ROCEs (descending order).

Company NameAvg ROCEAvg int covAvg D/E
Supreme Industries Ltd.
DB Corp Ltd.
BGR Energy Systems Ltd29.63.91.6
Godrej Properties Ltd.
Eros International Media Ltd.28.910.61.3
Motherson Sumi Systems Ltd.
Tulip Telecom Ltd.
KS Oils Ltd.
Balkrishna Industries Ltd.
Unitech Ltd.
Data Source: ACE Equity;
Note: All data is of the standalone entities, averages for all figures taken of past 5-years

We would like to inform readers that this list is displayed just to explain the concept. In case, readers do wish to bring these companies under their investing radar, it is urged that they study the companies and the respective sectors thoroughly before making their decisions.

Additional aspects that need to be taken into consideration...

Given the capital-intensive nature of some sectors, they tend to have relatively higher debt levels as compared to sectors such as FMCG and Information Technology, which are relatively less capital intensive in nature. Sectors that would fall in the former category would include power, steel, oil and gas, auto, amongst others.

So it goes without saying if one wishes to have a well diversified portfolio across sectors, he would do best to compare companies within a sector as compared to doing an inter-sector comparison for such parameters. For gauging, studying and comparing companies within a particular sector 'Return on invested capital' (ROIC) would be useful parameter.

As mentioned above, as long as a company is reinvesting its retained earnings into its core business (assuming it is earning strong ROCEs) is a positive. However, an important aspect that an investor would do well to understand is the status of the business cycle. If the cycle is on an uptick, then it would make sense for a company to invest more towards building up and expanding capacities. However, during times cycles reaching their peaks (in terms of demand), then taking on debt to build up more capacities would be negative as it would block capital towards unutilized assets. This would in turn, lower the return ratios of the company.

Also, debt taken in order to fund a reasonably large acquisition could kill the returns (provided the target companies health and return ratios are not better than that of the acquiring company) earned by the standalone entity.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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