Why You Should Pay Attention to Debt on the Balance Sheet

Investing

What is the most important thing in the stock market?

Earning money—isn’t it?

Wrong!

Saving your investment capital is the most important thing. Most often those who leave the stock market completely lose their hard earned money. That means they don’t have enough capital left to make money when the cycle turns.

Vishal Khandelwal, the ace investor and one of the most sensible voices in the Indian stock market has made it the mission of their life to guide investors so that they don’t lose money. This is the guiding principle of safalniveshak.com.

He pays a lot of attention to reading the balance sheet of the company since it tells a lot of things about the company in question.

So what does he see in the balance sheet?

‘Leverage’— he answered nonchalantly to Nikunj Dalmia of ET Now. You should keep away from the companies that borrow a lot of debt.

Let’s understand this example.

The Debt/Equity ratios of Ruchi Soya Industries=5.09. This means the company is 5 times more leveraged than equity!

That’s a bad sign, isn’t it?

The company must be borrowing to fund expansion from taking a lot of debt. For example, if you take a lot of loan to run your family or buy a new car—it’s a sure shot recipe to disaster. Ideally, you should do this from your own income.

Similarly, a company should be able to meet working capital expenses and growth plans from internal resources. No wonder the stock of Ruchi Soya industry fell from 69 Rs to 17 Rs in the last five years.

Most people in the stock market are enamored by growth. But ask yourself—at what cost the growth is coming? If a company is borrowing a lot of money, avoid that stock. In general, “one should avoid highly capital intensive stocks.” says Vishal Khandelwal to Nikunja Dalmia.

Similarly, you should avoid companies that need a lot of working capital to run the company.

Companies borrow funds from either shareholders or lenders. Excessive dependence on borrowings is risky. A company is considered financially sound only if a firm depends on its ability to repay principal and interest on borrowings even during bad times.

So how much debt on the balance sheet is permissible? The answer varies. Let’s see what Gods of investing think about it.

According to Benjamin Graham, long-term debt not to exceed current assets (current assets— current liabilities). Company’s cash plus inventory should be enough to pay its both short-term and long-term debt. However, many people consider it very strict.

Warren Buffett wants the company to have the ability to repay its long-term debt with no more than two years of its net earnings. He prefers a company with debt to equity ratio below 0.5.

So what happens if a company messes up by taking excessive debt? Take the example of JP Associates, which is on the verge of defaulting. Between 2006 and 2012, the group invested Rs.60,000 crore in real estate, power and cement by borrowing excessive amount of debt.

Jaypee, Rs.8, 000 crore 1,320MW Nigrie thermal power plant in Madhya Pradesh was funded by debt to the extent of 70%. Similarly the entire 1,000MW hydropower portfolio of Rs.7, 000 crore had a debt-equity ratio of 70:30.

If we apply Vishal Khandelwal’s views, he would simply avoid buying such stocks. Take another example of Bhushan Steel whose debt level started increasing fast.

Initially, company generated enough cash to repay debt but when financial capacity deteriorated its ability to pay debt decreased. It did the same mistake as that of JP Associates. The ratio of debt in the Odisha plant’s ₹19,400 crore expansion programme was funded by debt.

No wonder, it’s in such a mess!

In general, companies with a higher debt to capital ratio are financially vulnerable and they have greater chance of defaulting.

Hope you enjoyed the article. Please put your comments.

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