Over the last few years, investors have suffered hugely by investing in companies with high debt. Importantly, no one had a clue what was going on and were unable to understand how to judge and act in advance while these companies were piling on more debt.
Companies with high debt in books have destroyed investors' wealth hugely. Importantly evidence such as shareholding pattern suggests that savvy investors, mostly institutional investors, were able to sell early whereas retail investors were piling these companies in their portfolios in the hope of recovery in share prices.
There are enough financial tools that give early indication of companies which are in trouble or are facing financial trouble because of high debt in their books. Certain financial ratios are widely used and well reconsidered in terms of their utility in predicting financial distress, thus helping investors to take informed decisions and making prudent investments and protecting their capital.
Some of these financial ratios particularly used for assigning financial viability of high debt companies can be well used for early warnings and thus avoid debt trap.
Debt to Equity Ratio
To start with, debt to equity ratio is most important so that one can gauge earnings of the company. It is a relative ratio whereby one compares borrowed funds to owned funds.
Debt to equity ratio shows how leveraged a company is. In good times companies borrow excessively to fund their expansion plans, acquisitions and to finance their day-to-day operations.
As an investor, especially conservative investor will totally avoid companies with debt. But, some investors have more appetite, which allows them to invest in companies with debt.
Interest Coverage Ratio
Here the objective is to find out whether the company is able to meet its interest expenses. It is possible that in difficult times the company's earnings and cash flows are not enough to meet interest expenses. This could lead to huge losses and erode net worth of the company over a period of time and thus lead to a plunge in share prices.
In recent times we have already seen this happening in a number of cases like Kingfisher Airlines, Suzlon and HCC, among others who have suffered significantly because of their inability to meet interest expenses. Interest coverage ratio can be calculated by dividing earnings before interest and tax (EBIT) with interest expense.
High interest coverage ratio means that the company could easily meet its interest burden even if profits before interest and taxes were declining.
Low interest coverage ratio may cause financial embarrassment when earnings before interest and taxes decline and this could put pressure on financials of the company.
Working Capital Management
Industries which are highly capital-intensive require frequent funding. Importantly within these sets of companies which have very long cash conversion cycle require huge amount of working capital. For instance, a typical construction company's cash cycle could be as long as 200-300 days, which means the company needs working capital funding for its day-to-day operations.
To meet this, many companies borrow funds and this sometimes leads to huge working capital debt in the books, especially working capital loans, which are costly and could have a huge impact on the profitability in difficult times.
It is important to keep a close eye on components of working capital (inventory, receivables and cash) and how they are financed. Also, check if there is enough interest cover for such high working capital requirements.
In most cases one will find that working capital is the source of all debt-related problems. Working capital is calculated by subtracting the current assets of the company by current liabilities. The resultant figure is net working capital requirements of the company.
Debt Service Coverage Ratio
Many times looking at the income statement and balance sheet of the company it is hard to know if a company is able to service its debt. Companies keep on borrowing and use equity funds to pay interest and annual debt payments.
Thus, it will be hard to know from the profit and loss account if there are any issues pertaining to debt or the financial position of a company. This is precisely the reason why many investors use the debt service coverage ratio.
The debt service coverage ratio is very useful if someone wants to predict the sickness of any company. If the debt service coverage is inadequate, the probability of the company turning sick is very high. Here the investor first needs to know the debt payment obligation and interest that the company is supposed to incur every year.
If that amount is less than cash flows from operations, which could be earnings before interest, depreciation and interest, it will give a warning sign. This means that the company's annual cash flows from operations are not sufficient enough to meet the annual debt repayment as well as interest burden.
In this case investors should keep a close eye on the cash flow statement (CFS) and fund flow statement (FFS), which will give enough indications of how the funds are used and from where they have come.
Solvency ratio is used to determine the long-term solvency of the company. It tries to figure out if the company is earning enough to service its debt as well as other long-term liabilities of the company.
In this the investors have to find out the current net profit of the company and then add back non-cash transactions such as depreciation. This will provide cash earnings of the company, which will then be divided by the total liability of the company.
We can find current ratio by dividing current assets with current liabilities. Typically current assets should be higher than current liabilities, which will indicate that the company is able to meet its short-term obligations and liquidity issues.
Importantly, one needs to keep a tab on receivables and inventory in terms of the how they are moving in relation with turnover and current liabilities. Also, valuations of inventory and soundness of receivables needs to be calculated to understand liquidity positions of a company.
Sometimes investors do not rely much on the current ratio. They think that the inventory is less liquid and in case of immediate needs they cannot be realized and thus could put pressure on the company at times.
To deal with this, investors calculate quick ratio, also known as liquid ratio. It can be found out by dividing the sum of cash and accounts receivables with current liabilities.
Since cash and accounts receivables are considered to be most liquid assets of a company, the ratio indicates how quickly the company can meet its current liabilities.
Debt to Total Assets
Today asset monetization is very important as many companies are trying to sell assets to retire their debts. Knowing debt figures may not give a true picture. If high debt in the books is supported by hard assets, sometimes non-core assets such as land bank, investors may not worry as much.
Investors should also go the extra mile and try to understand the market value of such assets, which may be lower or higher than the book value of such assets. In this case assessment of debt could change and the organization's ability to retire such debt could change. It could also help it in borrowing at lower rates because of lower risk. If the company is not able to service its debt through earnings and operating cash flow, then in difficult times it has to resort to fixed assets to retire debts.
Enterprise Value to Operating Profit (EV/EBITDA)
Finally the most important thing is valuations. Companies with debt are valued entirely differently unlike companies with zero debt. This is also the reason why many investors make mistakes and keep on buying at lower prices, ignoring debt in the books.
Market capitalization or an earnings-based ratio in this case may not work perfectly, which is why informed investors use ratios like EV by EBITDA. While EV is market capitalization of the company plus debt in the books, EBITDA is earnings before interest, tax, depreciation and amortization, which also connotes operating profits.
An earnings-based ratio hides these facts and does not reflect the true value of the company. This is the reason why EV by EBITDA is considered to be a more appropriate matrix for valuing companies with debt in their books of accounts.
Source: Nirmal Bang's Beyond Market
Click here to read the full magazine
Disclaimer: The views and investment tips expressed by investment experts/broking houses/rating agencies 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.