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Friday, June 16, 2017

Does large debt on the Balance Sheet make a company's stock a risky investment?

It is that time of the year when Annual Reports of companies will be hitting mailboxes. Instead of just checking the dividend amount and tossing the report in the recycle bin, it may be worthwhile to go through the report.

At the very least, the balance sheet, P&L, cash flow statement and the notes to accounts should be studied. These will reveal the financial health of a company.

One of the things that get many companies into trouble is trying to grow too fast, too soon. Many tech companies had fallen prey to the syndrome of 'grabbing eyeballs' instead of having a solid business plan that would lead to cash generation.

They had taken on a huge amount of debt to gain market share quickly by expanding globally or by acquiring competitors. Their subsequent bankruptcies were caused by the inability to service their debts.

Even the well-established houses of Tatas and Birlas made gross errors of judgement by financing their acquisitions of overseas competitor companies through large debt.

But what if taking on large debt to buy out a competitor actually results in increasing market share and enabling a move up the value chain? Tata Motors did that successfully by acquiring Jaguar-Land Rover from Ford.

So, how does a small investor decide if large debt on the Balance Sheet of a company makes investment in its stock risky or not? 

One way is to look at the Interest Coverage ratio. Another is to look at the Return on Capital Employed (RoCE) ratio. The higher the ratios the better. Both these ratios should be compared with other companies in the same sector.

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