When it comes to the question, ‘how to select stocks’, something we do regularly for our portfolio management service (PMS), we usually prefer companies with zero debt. After all when bad times come who wants to be stuck with companies that are in turn stuck with large interest payment bills. However there are many situations when having some debt can be an advantage.
Sources of Financing
Typically, companies handle their finance needs through equity, debt, or cash generated from operations internally. Internally generated accruals are also part of Owners’ equity, although money is not explicitly coming from Bank account of Shareholders. Of these sources, cash accrued internally is the most preferred form of finance, followed by debt, while equity is the least favoured source.
A good company would expand organically by accumulating profits over time, adding the surplus to its reserves. It would reinvest in new capacity and execute well to earn more profits. Debt is a costlier source because there are clear costs associated. Debt carries an explicit cost in the form of interest, irrespective of how it is structured.
Taking on Debt implies taking on a financial commitment, which needs to be met irrespective of the financial performance or financial position of the company. Equity is least favoured, not just because the company’s promoters reduce their ownership and control in the company, but also because they have to pay out a share of the earnings indefinitely. For this reason, Equity is considered as the most expensive source of finance.
There are various other instruments such as Preference Share Capital, Convertible Instruments, Warrants, etc, which are all a combination of various features of debt and equity.
While The Capital structure of the company, or the debt/ equity mix, is a very important aspect of Financial Management. It is also true that, sometimes companies do take advantage of moderate amounts of debt. It is particularly difficult to avoid debt in capital-intensive businesses such as iron and steel, cement, telecommunications, and so on. Equity shareholders may be hesitant to contribute 100 percent finance for such initiatives because doing so would dilute equity and lower earnings per share. It is easier for these industries to raise loans because they have fixed and physical assets.
Other industries such as Information Technology, do not need to invest in heavy ‘plant and equipment’, and have no debt nor do they face interest rate risk. They do, however, face a variety of other financial risks such as currency volatility, wars, economic situations in other geographies such as the United States, Europe, and other major export markets. The key takeaway here is that every firm is exposed to some financial risk depending on their industry’s nature. To that extent one need not conclude that the industries that take on some debt face higher risk. In fact, some debt could be of benefit in many ways.
Benefits of Strategic Borrowing
There are multiple advantages that strategic borrowing can offer to businesses, challenging the conventional wisdom of ‘zero debt’ and underlining its potential to bolster balance sheet resilience along with driving business agility.
Tax benefits and RoI Boost
One of the notable advantages of strategic debt financing is the tax shield it offers. The concept of a tax shield is tied to the principle that interest expense on debt is tax-deductible, thereby reducing the overall tax liability of the company. This aspect can make debt an attractive financing option compared to equity financing, where dividends (a form of returns to equity shareholders) are paid out of post-tax profits and are not tax-deductible.
Here’s an illustrative example. Consider two firms – Firm A and Firm B – both generating a pre-tax income of INR 10,00,000. Firm A has no debt, whereas Firm B has a strategic debt on which it pays an interest of INR 2,00,000.
|Firm A||Firm B|
|Return on Equity||14.00%||18.67%|
Assuming a tax rate of 30%, Firm A would pay INR 3,00,000 as taxes, retaining INR 7,00,000 as post-tax income. However, Firm B, thanks to its interest expense, has its taxable income reduced to INR 8,00,000 (10,00,000 – 2,00,000). Thus, its tax liability comes down to INR 2,40,000, leading to a post-tax income of INR 5,60,000.
By using debt to fund its business, the company saved tax expenses to the tune of Rs.60,000. Readers would note that this leaves lesser money for the Equity Shareholders, as PAT has gone down from Rs.7 lakhs to just Rs.5,60,000. However, this is on a lower Equity investment of Rs.8,00,000. Thus, the RoI for Equity shareholders will now be 18.67% (Rs5.60,000/30,00,000*100), higher than 14% (Rs.7,00,000 / 10,00,000 *100), if the entire funding was in the form of Equity.
This represents an effective use of the tax shield benefit, enabling Firm B to save on taxes, retain more income and generate more RoI for shareholders. The tax benefits from strategic debt offer an attractive avenue for companies to lower their cost of capital and enhance their net income, making it a key consideration in a company’s capital structure decisions.
Strategic debt deployment can reshape a company’s equity base and influence its ROE. When a company resorts to strategic debt, it effectively replaces a portion of its equity capital with borrowed capital. This reduction in equity capital can subsequently increase the ROE. This happens because if a company borrows at a cost (interest rate) lower than the returns it generates on its capital, it can increase its earnings relative to equity, thereby driving up its ROE.
TCS, a leading player in the global IT services industry, has consistently showcased robust ROE due to its almost debt-free status. However, if TCS were to strategically use debt, for instance, for an acquisition of a high-value target, it could enhance its net income, and consequently, its ROE, while maintaining a low debt-equity ratio.
The mantra to consider strategic debt would be to see if Return on Capital Employed is greater than Cost of Debt. If yes, having debt would enhance RoI. However, if RoCE is less than cost of debt, then debt will further pull down RoI for equity shareholders
However, this is not a one-size-fits-all strategy. We must always remember that Debt is a double edged sword. It requires a judicious balance of potential benefits and risks of increased financial leverage. It’s not merely the magnitude of ROE that matters to long-term investors, but the sustainability and consistency of ROE over time.
In case of TCS and many IT companies, we can note that their working capital is significantly tied in to meet fixed expenses such as Salaries and Rent. In other words, such companies need to incur such expenses even when the company is facing recessionary situations, which pull down revenues. This adversely impacts profitability. Such companies would not want to add additional burden of fixed interest payments on its financials. That explains why many companies choose to be debt free or relatively low debt.
Easing of Cashflows
When strategically deployed, debt can serve as a potent tool to ease cash flow pressures, facilitating business expansion and fostering innovation. Take, for instance, the case of Tata Motors. Back in 2008, Tata Motors undertook a strategic debt financing move to acquire the iconic British luxury car brand Jaguar Land Rover. The acquisition, funded largely through debt, has proved to be transformative for the company, driving significant revenue and profit growth.
While there are companies that embrace debt financing as an integral part of their growth strategy, there are others who master the art of minimalism in debt, utilizing it sparingly yet strategically,showcasing the importance of prudent debt financing decisions. A careful scrutiny of such companies can offer invaluable insights into how strategic debt management can work in tandem with disciplined fiscal prudence.
A good example is Hindustan Unilever Ltd (HUL), one of India’s leading fast-moving consumer goods (FMCG) companies. HUL has historically maintained a low debt-equity ratio, typically below 10%. This conservative approach to borrowing reflects the company’s robust operational efficiency and its ability to generate significant cash flows from its operations. Yet, the company has not shied away from utilizing debt judiciously to fund strategic acquisitions, such as the acquisition of GlaxoSmithKline’s India consumer business in 2020. This blend of fiscal discipline and strategic debt usage underscores the company’s acumen in navigating its financial landscape.
Another example is Infosys. Just like TCS, Infosys has maintained a debt-equity ratio that is enviable, often close to zero. Yet, the company understands the strategic value of debt; it raises funds whenever it spots a valuable acquisition or an investment opportunity that aligns with its long-term strategic objectives. A case in point is the company’s acquisition of the US-based Simplus in early 2020, partially financed through debt financing, that enabled Infosys to strengthen its position in the Salesforce ecosystem.
A low debt-equity ratio, combined with the strategic use of debt, can be indicative of a company’s financial resilience and its capacity to capitalize on growth opportunities while maintaining a strong balance sheet. As astute investors, our task is to identify such companies, which know how to sail with the winds of debt, maintaining a steady course towards sustained financial health.
In essence, strategic debt can serve as a fulcrum that balances a company’s growth ambitions with its cash flow realities, making it a critical aspect of debt financing and overall financial management. The ability to prudently deploy debt is a testament to a company’s financial acumen and strategic foresight – attributes that, as discerning investors, we must vigilantly seek out. Remember, as we traverse the landscape of financial analysis, let’s strive to perceive debt not merely as a liability but as a strategic instrument that, when played correctly, can orchestrate a symphony of growth and financial stability.
Low interest rate regimes
During the immediate aftermath of Covid-19 we have seen central banks slash down interest rates aggressively. When interest rates are lower, it’s more affordable for consumers to borrow the money they need to finance homes, cars, education, and other forms of consumption. In general, lower interest rates are seen as ‘stimulative’ for the economy, as consumers tend to buy more, businesses invest more, and governments can afford social programs.
The main objective was to give relief to businesses and ensure they don’t resort to massive layoffs. The idea was to also help companies take advantage of the lower interest rates (in many western countries, these rates were near zero) to expand their capacity. Companies anyway need readily available credit to invest in their businesses, pay their employees on time, and manage their cash flow effectively.
The flip side of this, that must be noted by the investor, is that very low interest rates result in propping up ‘almost dead’ companies. Bailouts of the kind doled out at Wall Street by the US govt in 2008 after the Global Financial Crisis are a redistribution of the taxpayer’s money to the profligate offenders. Extremely low interest rates end up punishing good companies and reward the recklessly extravagant by allowing them to refinance what should have been deadly debt loads.
Indian companies often tap the route of borrowing overseas given the favourable and steady borrowing costs abroad supported by stable outlook for the rupee. India’s adequacy indicators, such as import cover and short-term debt to reserves, have been strong during this decade compared to other emerging markets. India’s external debt ratio to GDP has been favourable compared to many emerging market economies. The ratio of external debt to GDP has fallen in the last five years from 23.8% in March’15 to 20.6% in March’20 and debt service ratio fell from 7.6 per cent to 6.5 per cent.
If the US 10-year Treasury Bill yield is very low, them the borrowers’ funding costs are also low. Companies like the Reliance Group, the Adanis, and the Aditya Birla Group are amongst the largest borrowers. There is a significant foreign exchange risk here though. While an appreciating local currency reduces the burden of global repayments for local borrowers, the converse may hit them hard. Therefore, a large old economy company may benefit from external commercial borrowings provided it can handle the forex risk. A stable rupee outlook can make this proposition more attractive.
Faster Capital Deployment & Agility
Debt can be raised fairly quickly unlike equity which takes a lot of institutional and regulatory activity. Therefore, sometimes a company that can raise debt and expand capacity in terms of new plant and machinery can be seen as proactive. Seizing the early mover advantage can be viewed favourably by potential investors.
To summarise, an investor should consider not just whether a firm is debt-free or debt-laden, but also a variety of other aspects such as the nature of the industry, the business model and its long-term viability, financial history, earnings multiples, and so on. Debt is likely one of the factors in a company’s valuation, because a lot of the valuation math is derived from the estimated free cash flows, earning streams (implicitly the growth thereof), depending on the company’s potential.
It’s possible that lumping debt-free and debt-heavy businesses together without considering their unique characteristics and risks might make the investor overlook some good companies. From a “ROOTS” standpoint we might consider some allowance for these factors when looking at how to select a stock into our portfolio.