X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Should one always ignore high debt companies? - Views on News from Equitymaster
 
 
  • PRINT
  • E-MAIL
  • FEEDBACK
  • A  A  A
  • Jul 6, 2012

    Should one always ignore high debt companies?

    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 Name Avg ROCE Avg int cov Avg D/E
    Supreme Industries Ltd. 30.8 4.8 1.1
    DB Corp Ltd. 30.2 9.5 1.1
    BGR Energy Systems Ltd 29.6 3.9 1.6
    Godrej Properties Ltd. 29.5 4.7 1.3
    Eros International Media Ltd. 28.9 10.6 1.3
    Motherson Sumi Systems Ltd. 25.2 8.4 1.1
    Tulip Telecom Ltd. 24.2 7.3 1.4
    KS Oils Ltd. 24.1 3.5 1.1
    Balkrishna Industries Ltd. 23.0 10.2 1.0
    Unitech Ltd. 22.1 4.2 2.2
    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 (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.

     

     

    Equitymaster requests your view! Post a comment on "Should one always ignore high debt companies?". Click here!

      
     

    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    More
    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407
     

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Aug 18, 2017 (Close)

    MARKET STATS