Too much debt and falling cash flows are not good signs for a company.
Having debt on its books is not all that bad for a company if it has sufficient cash flows to pay the interest on it. A company that is on a growth path will not mind taking on some debt because it could lead to an increase in return on equity (RoE).
However, too much debt and falling cash flows are not good signs for a company. Recent data suggests that the overall corporate stress increased in the March quarter, as the proportion of debt with companies having interest cover (IC) of less than 1 increased to 41 percent from 39 percent in the previous quarter, according to a report from Credit Suisse.
But the increase was on account of Bharti Airtel seeing its IC fall below 1 this quarter, as a result of which the share of chronically stressed debt (IC<1 for 4 or more of the last 8 quarters) declined to 35 percent, as a couple of large steel accounts exited the list.
The total debt of Credit Suisse's sample was $540 billion and the share of debt with loss-making companies has remained stable at 29 percent, which is a good sign. The overall profitability also improved in Q4, aided by the low base. EBITDA increased 19 percent YoY and 4 percent QoQ.
Companies highlighted by Credit Suisse in its report titled 'India Corporate Health Tracker' include names like Bharti Airtel, Idea Cellular, Adani Power, Tata Power, Reliance Communications, Jaiprakash Associates, Reliance Infrastructure, DLF, IL&FS Transport, and Jaiprakash Power Ventures, among others.
Before we proceed further, let us understand what is interest coverage ratio (ICR). In simple words, it helps investors determine how easy or tough it is for a company to service its debt. It is calculated by dividing a company's earnings before interest and taxes during a given period by its interest payments during the same period.
ICR = EBIT/Interest Expense
Interest coverage ratio helps in deriving margin of safety or essentially, how many times over a company could pay its current interest payment with its own earnings. However, the margin of safety for interest coverage differs from industry to industry.
The rule of the thumb is that if the interest coverage ratio is less than 1, it means that there is a higher debt burden on the company, and investors should remain cautious.
"We prefer companies having interest coverage ratio in between 2-3 times. If interest coverage ratio is less than 1, how the company will pay interest expense. We don't advise to invest in heavily leveraged companies," BV Raman, Head - Investing Business, Way2Wealth Brokers, told Moneycontrol.
"But, if the company has significant non-core assets and monetization of assets can deleverage the balance sheet, we can check those companies but still it’s a very risky investment considering risk reward. We always avoid such type of investments and there are various case studies to prove that like Suzlon, GVK, GVR, Adani Power, Lanco Infra, CG Power, etc," he said.
A delay in asset monetization hampers the balance sheet heavily and shaves off assets' value by way of extra interest expense, which could be saved by monetizing assets on time.
Performance of stressed companies over the last 10 years has not been up to the mark. Almost all of them have given negative returns in the decade gone by, with some of them having lost as much as 90 percent of their value.
Interest coverage is the factor that helps an investor determine whether the company is capable of paying the interest charges on the debt.
If a company is able to consistently report good earnings even after paying all its interest dues, it is considered as a good investment bet against one that is barely able to cover its interest cost. Such companies may easily go bankrupt if earnings keep suffering every month.
"If we have a look at the companies such as DLF limited, Reliance Communications and Idea cellular the Interest coverage ratio is in negative which means the company’s ability to pay the interest costs is very much adverse which is a huge risk factor for an investor," Ritesh Ashar, Chief Strategy Officer at KIFS Trade Capital told Moneycontrol.
"The ideal way to diversify the risk is to sell out the holding and look at investing in other companies with a better interest coverage ratio," he said.
What should investors do?
Companies with high debt burden and low-interest coverage may usually be avoided if there are no or little signs of earnings growth cushion, suggest experts.
"Out of the list of companies having poor interest coverage along with high debt burden, one may shift from Tata Power to CESC, DLF to Mahindra Lifespaces and IL&FS Trans to Capacit’e Infra," Vineeta Sharma, HOR at Narnolia Financial Advisors told Moneycontrol.
Explaining his rationale, Sharma said that CESC's distribution business has a stable RoE of 19 percent with a steady growth profile. Mahindra Lifespaces has a lighter balance sheet now, and Capacit'e Infra is expected to report a rise of 30 percent or more in profit, with debt-equity ratio at 0.25.
Raman of Way2Wealth Brokers highlights Tata Power as an attractive investment opportunity at the current price.
"The company has huge assets and if the company gets success in importing coal from Russia at competitive prices, it will change the outlook of the company," he said.
Another stock that is still attractive is JSPL. The company's FY18 consolidated EBIT was Rs 2,586 crore and its finance costs came in at around Rs 3,866 crore.
"For the last 3-4 years, JSPL was undergoing a very large capex almost tripling its capacity. We expect strong volume growth ahead," said Sharma of Narnolia Financial Advisors.
"And, from here on there would high free cashflow generation. We are estimating close to Rs 15,000 crore of free cash flow generation over the next 2 years and that would help the D:E become 1:1 from 2:1 in FY15," he said.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.