Debt can hit firms hard
In understanding or analysing any company, the most commonly used document is the annual report. The annual report has, among other things, a ‘profit and loss’ account and a ‘balance sheet’ . The P&L tells us what happened in the period under review in terms of sales, the costs incurred in reaching those sales and the resultant profit or loss. A balance sheet gives you a position of what the company owns and what the company owes. A strong balance sheet can help a company weather a couple of bad years on the P&L. However, a weak balance sheet is like a fairweather friend. In good times, it makes things look brighter and in bad times, it can sink you without hopes of a recovery.
In a bull market, most people look just at the bottom line or the profit numbers and some related things like EPS etc. The balance sheet is ignored. When the tide turns, those companies that have weak balance sheets, will tend to implode. Most research reports from brokers will simply talk pages about market shares, profits and not talk much about the cash flow or the debt on the books. Their analysis is heavily dependent on the P&L account.
One important health indicator in a balance sheet is ‘debt’. Once a company is mature, it should be logical for a company to keep reducing its debt and become debt-free. It’s profit generation should be sufficient to wipe out debt and keep growing. It does not mean that it will come to raise equity capital every year. If we look at great companies like Nestle, Colgate, Bajaj Auto, Hero, Asian Paints etc, you will understand what a healthy balance sheet means. These companies are market leaders in their businesses and highly profitable. They will not have debt on their books.
A company with no debt has greater freedom to take risks and explore new options. A company laden with debt does not have this luxury. Take the case of the ‘infrastructure’ companies. In the heady days of 2007-08, they took on loads of debt and were banking on continuous placement of equity at huge premiums, to finance their business. Soon, they lost everything and collapsed under the burden of debt. A couple of them, with no debt to very low debt, survived and are now in capitalising by being able to execute new orders. Same is the case in the real estate sector. Those builders who borrowed and got stuck with unsold inventory, are in a soup. Commodity companies with wafer thin margins and high debt also became victims of poor balance sheets.
I like to look at the net profit of a company in relation to its total debt. If the total debt of a company is higher than four to five year’s net profits, then I think that the company is very high risk. One turn in the business and they will default. These companies have to raise fresh capital to keep going or keep finding new debt to replace the old. Such companies are high risk opportunities.
Just like debt, there are companies that are stressed for cash. Their current assets (debtors and inventories) grow faster than their sales do. This means the business is too competitive and they are likely to face a cash crunch plus debt write offs in the future. A business that is 10 years old, ought to manage cash flows in a manner that the total debt actually reduces in absolute numbers and finally gets extinguished. Yes, there are companies which like to grow furiously by taking on new projects year after year. They are living dangerously and are banking on the friendly banking system to support them in bad times.
It is true that leverage (debt) helps to boost shareholder return. However, that can happen only when the business earns a rate of return that is significantly higher than the cost of borrowing. If a company can do it successfully, year on year, then the cash thrown up will make it debt free! Just look at the Return on Equity (RoE) of debt free companies like HUL or Colgate or Nestle and compare them with any company with debt.
For long term investments to pay off, the one sure test is a balance sheet test. Do not forget the balance sheet and the cash flow. These two analytical tools can help keep you away from potential disasters. The P&L is only the dressing on the salad. And quarterly numbers are even more of a dressing than the annual ones. (The write is a veteran investment advisor. He can be contacted at balakrishnanr@gmail.com)
Most research reports of brokers simply talk about market shares, profits and not talk much about the cash flow or the debt on the books.