Investors should give equal importance to sector outlook, business efficiency and ability to turn around the business.
Debt is an important aspect of a balance sheet especially for capital intensive companies but too much of debt without adequate cash flow will start to hurt margins.
A lot of companies with excessive debt on the books are struggling to keep up with repayments. A scenario which was brought to light by the Reserve Bank of India (RBI) last week when the central bank released a list of top 50 stressed accounts which need immediate attention.
However, companies which have been instrumental in bringing down their debt exposure got rewarded handsomely by the market. Almost 100 companies which have reduced their debt more than doubled investors’ wealth in the last one year, Capitaline data showed.
Prominent companies which have reduced debt burden include names like Indiabulls Ventures, Jindal Stainless, Phillip Carbon, Lumax Industries, Venky’s, Prime Securities, GTL Infra, Future Lifestyle, Shakti Pumps, Vardhman, National Fertilisers, Dalmia Bharat etc. among others.
Additionally, more than 700 companies on the BSE saw debt reduction on the books of accounts which also got rewarded by markets handsomely.
“Yes, paying off debt obligation didn’t go unnoticed by the Street. The sentiment of the market towards companies’ capacity to service or to reduce their debt from balance sheet has given positive traction in stock returns within a span of time,” Dinesh Rohira, Founder & CEO, 5nance.com told Moneycontrol.
“Indiabulls Venture, for instance, saw a 28 percent reduction in debt obligation from 2016 to 2017 while the stock generated 3 digit returns during the same period. A timely servicing of a debt obligation reduces the cost of interest associated with borrowing and it also increases the profitability margin with lower interest expense,” he said.
Interest coverage ratio or ICR is calculated to ascertain the capacity of the company to service debt or pay interest on outstanding debt. It is calculated by dividing the Earning Before Interest & Tax (EBIT) by Interest expenses.
Reduction of debt is important but it will not be right to take an investment call just based on one indicator.
This is just one indicator which investors’ should use to determine the relative attractiveness of the stock but to become a strong play in the market, a fundamental soundness should be taken into consideration.
Investors should give equal important to sector outlook, business efficiency and management’s ability to turn around the business when faced with the toughest working environment.
Mounting concerns over loan default by various companies coupled with broadening size of non-performing asset (NPA) in the banking sector have brought the financial health at edge eruption, suggest experts.
“We cannot paint all the mentioned companies with the same colour. However, in a general sense, certainly, reduction of debt is a strong signal to the market implying prudent fiscal/balance sheet discipline,” Pankaj Pandey, Head of Research, ICICI Direct told Moneycontrol.
“It is more rewarding for the shareholders if the reduction in debt is driven by operational efficiencies amid healthy cash flow generation from operations. Some companies in the aforesaid list have certainly become a strong play in the market, the case, in particular, is a leading tyre chemical manufacture,” he said.
What should investors do?
Regular repayment of debt is an indication of healthy cash flow and it also improves chances for rerating. However, only debt repayment is not sufficient, business outlook, product portfolio and management integrity are important as well, suggest experts.
“Most of the given companies are trading at very high valuation and we believe that most of the positives are priced in. We need to look at next couple of quarter results to see the consistency, before considering it as BUY,” Tushar Pendharkar, Head of Research, Right Horizons Investment Advisory Services told Moneycontrol.
“Companies operating in Autos, Infra and Discretionary segment would get the maximum benefit because the outlook for these sectors is strong,” he said.
Pandey of ICICI Direct said that investment in a stock warrants a detailed study and should always be company specific rather than debt reduction being a universal buying signal.
“Only if the business prospects are brighter for such stocks one should use this opportunity to continue holding the stock or initiate a fresh Buy,” 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.