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.

Read more. 

8 Signs of a Doomed Stock

Let me assume that you have been following my posts regularly, and are no longer swayed by stock market cacophony and 'expert tips' sent by SMS to your smart phone.

You have been doing due diligence and picking stocks based on solid research. Already some of them have moved higher since you bought them.

But there are these one or two exceptions that are refusing to move up. In fact, they may be gradually sliding down despite apparently good track records.

As a long-term investor, what are you supposed to do with the laggards? Hold on, and hope for prices to improve? Buy more as the stock is now available at a price lower than your 'buy price'? Get rid of it?

In a recent video posted at investopedia.com, you can check out more information about the '8 Signs of a Doomed Stock':

1. Negative cash flows from operations
2. High debt/equity ratio
3. Low interest coverage ratio
4. Sustained decline in price
5. Profit warnings issued before or during quarterly results
6. Large selling by owners/directors
7. Resignations by key executives/managers
8. Investigations by SEBI/Enforcement Directorate/Income Tax department

Any one of the above signs may not be enough to warrant selling. But several of these signs taken together is almost a guarantee that the stock's price will crash.

Related Posts

What does the Debt/Equity ratio indicate?

What does the Interest Coverage Ratio signify?

Fundamental Analysis: Solvency ratios and Liquidity ratios

Selecting a company for investing is not a trivial task. Many small investors get into trouble because they buy a stock without doing adequate homework. 

A stock may be in the news as a potential multibagger, or may be approaching its 25th or 50th year of existence or has a reputation of distributing large dividends.

Those may be good reasons for someone to buy the stock in the hope of making some quick gains. But for building wealth for the long-term, more detailed analysis is necessary to determine a company's staying power.

Ratio analysis is a good way to differentiate a company from its peers and competitors. But there are so many ratios to analyse - where should you start?

The state of financial health of a company is one of the first things you should evaluate. If the financial foundation is strong, many other shortcomings can be overridden.

Solvency ratios - like debt/equity and interest coverage - indicate the ability of a company to meet its long-term financial commitments.

Liquidity ratios - like current ratio and quick ratio - indicate how well a company can meet its short-term financial obligations.

To learn more about solvency and liquidity ratios - how to calculate and evaluate them - visit the following links at investopedia.com:

Link 1

Link 2

How to use the Market Cap to Sales (or Price to Sales) ratio to value stocks

Before learning when and how to use the Market Cap to Sales (or Price to Sales) ratio, some definitions may be in order.

Market Capitalisation (Market Cap) = Total number of equity shares x Price per share

If the equity capital of a company is Rs 10 Crores and the face value of each share is Rs 10, then the company has issued 1 Crore shares. If the share price is Rs 50 (on a given day), the Market Cap (on that day) is Rs 50 Crores. As is evident, the Market Cap is a number that changes with the share's price.

Why should we be concerned about this number? It represents the total value of the company in the stock market. In other words, if you had a lot of money and you wanted to buy the entire company (which has to be listed in the stock exchange), then you will have to pay an amount equal to the Market Cap, i.e. Rs 50 Crores.

The Market Cap to Sales ratio, also referred as the Price to Sales ratio (P/S or PSR), is calculated by either dividing the Market Cap by the total sales of the previous 12 months, or by dividing the share price by the per-share sales of the past 12 months.

P/S or PSR = Price per share/Sales per share = Market Cap/Total Sales

If the company in our example had sales of Rs 80 Crores in the previous year, its Market Cap to Sales ratio will be 50/80 = 0.625. A ratio less than 1 is considered a sign of 'under-valuation'. Why? It means that for each Re 1 of sales you will be paying 62.5 paisa if you were buying the entire company.

If another company in the same sector has a similar equity capital, but a share price of Rs 60 and sales of Rs 100 Crores, then its Market Cap to Sales ratio will be 60/100 = 0.6. That means, the higher priced share is actually 'cheaper' valuation-wise.

This is an important point for small investors to note. Many say that they have limited capital and therefore, opt to buy shares that are cheaper in price. They end up buying a small cap or mid cap share. Valuation-wise, a higher priced large cap may be a better buy.

Please remember that different sectors have different operating criteria. Some require heavy capital expenditure, others don't. Some sectors have low sales and high profit margins. Others have large sales but low profit margins. The Market Cap to Sales ratio should be used only for comparing companies within the same sector.

Several other ratios, like Debt to Equity, Interest Coverage and Return on Assets, had been discussed earlier. Do we really need to look at another ratio? The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses. Because they have no earnings, the more popular valuing metric P/E can not be used.

As a general thumb rule, small investors should avoid loss-making companies. What if an otherwise fundamentally strong sector or company gets into a temporary difficulty and incurs losses? It happened to Tata Motors and Hindalco. It happened to the export-oriented textile sector. The Market Cap to Sales ratio will help to separate the men from the boys.

Many analysts prefer to use the P/S ratio over the P/E ratio, because it is easier to fudge earnings, whereas sales can be more readily verified. That does not mean a 'creative' company like DLF can't fudge their sales figures!

It is best to check both the P/E and the P/S ratios when selecting a company from a particular sector. If both indicate 'under-valuation', then the stock can be included in a 'buy' list. If the indications are contrary to one another, it is an alarm signal that management is probably doing some fudging.

Debt-burdened companies often trade at low Price to Sales ratios. Their sales may not be affected and may actually be growing, but interest and capital repayments may be causing a drop in margins and cash flows. Investors should avoid such 'value traps' by checking the Debt/Equity and Interest Coverage ratios.

(A short exercise for readers: In the recent stock selection exercise, most readers chose Stock 'N' as the best of the three. However, on the basis of the Market Cap to Sales ratios, Stock 'N' is more expensive with a ratio of 0.79. Stock 'S' and Stock 'I' have ratios of 0.47 and 0.46.

Will readers still choose Stock 'N' over the other two? If yes, why? If no, why not?)

What does the Interest Coverage Ratio signify?

The Interest Coverage ratio (also called Times Interest Earned) is another measure of a company's financial health. It signifies the ability of a company to meet its debt obligation.

In earlier posts, I have covered Current Ratio, Quick Ratio and Debt/Equity ratio. These financial ratios, together with cash flows from operations give a clear view of the financial soundness of a company.

The definition of the Interest Coverage Ratio is simple enough. It is the EBIT divided by interest expense:

EBIT is the earnings (or Profits) before interest and tax payments. It is calculated by adding the interest expense to the PBT (Profits Before Tax). The PBT and interest figures can be obtained from the Profit and Loss statement in any Annual Report of a company.

Let us look at Maharashtra Seamless' Mar '09 annual figures. PBT was 385 Cr; interest expense was 11.6 Cr. That gives an EBIT of (385+11.6=) 396.6 Cr. The interest coverage ratio is 34.

What does that mean? Maharashtra Seamless can pay its debt obligation 34 times with its earnings before interest and taxes. Let us look at another company - 3i Infotech, which is quite popular with small investors.

PBT was 288.5 Cr; interest expense was 95 Cr for year-ending Mar '09. EBIT = 383.5 Cr, not much lower than that of Maharashtra Seamless. But the difference in the interest coverage ratio is startling - an adequate 4, against a very comfortable 34!

An interest coverage ratio of less than 1.5 means that the company may have trouble meeting its debt obligations and may need to borrow more to pay its previous debts. A ratio less than 2.5 should be treated as a warning sign. Avoid companies with a ratio less than 1.

It is important to check a company's financial health over the past 5 years or more. A decreasing interest coverage ratio - even if it is above the threshold values mentioned - is a red flag. Look for companies with consistency of earnings. They can afford to have a lower interest coverage ratio - though the higher the ratio, the better their financial health.

Conservative investors can use a more stringent ratio, by using only EBI on the numerator. That is, they should deduct the tax amount from EBIT before calculating the Interest Coverage Ratio.

This concludes the series of posts on how to evaluate the financial health of a company. Readers may want to go through an exercise of calculating the financial soundness of stocks in their portfolios. The time spent will be well worth it.