Does it make sense to invest in cash rich debt free companies in India and how to go about identifying such companies? There can be no clear answers but in a situation where financial prudence is at a premium, companies with low debt and high levels of cash flows will surely command a premium.
What do we understand by debt free companies?
One simple way to define debt-free companies is a zero debt company. But you can also extend the definition to be a little more flexible and include companies that have very low debt/equity ratios. What is so unique about debt free companies? They are capable of withstanding any type of economic cycle and sudden disruptions like we are seeing in the Coronavirus case. Take the example of debt free companies like Hero Moto, Infosys, TCS and Bajaj Auto. Their low debt status makes them the best bet in difficult market conditions. A low debt company has high creditworthiness. Also, these companies are able to buy growth and expand margins much faster than high debt companies.
Why understanding debt/ equity is the key to screening companies
The first and simplest step is to focus on the debt-to-equity ratio. This is the most popular metrics of measuring the financial solvency and health of a company and is defined as:
Debt to Equity Ratio = Total Borrowings / Total Shareholder Equity
The basic thumb rule is that a company with lower debt to equity ratio is good for investment. If that sounds intuitive let us look at practically examples. Highly indebted companies like RCOM, Reliance Infrastructure, Suzlon, GMR, GVK and JP Infra have been among the biggest value destroyers in the last 10 years. On the other hand the debt free companies have created real wealth in the last 10 years. A company using too much leverage tends to dilute the revenue available to equity holders substantially. . It is not advisable to invest in the company with higher debt to equity ratio. Let us now look at how to screen such zero debt and high cash flow companies.
How to screen zero debt and high cash flow companies?
Indian markets have traditionally shown preference for companies that stay away from debt and fund their operations largely from internal accruals. Most of the large software companies built their multi-billion dollar valuations on a zero-debt model. You may be surprised to know that debt-free companies make up for 57% of the current market capitalization of listed non-financial companies even.
Now let us shortlist low debt companies based on 3 criteria.
- Firstly, we look at companies with D/E ratio of zero or having no debt in its books at all.
- Then we focus on companies with a huge Interest Coverage Ratio (ICR) which measures how many times the EBIT covers the interest cost.
- Finally, we also look at companies with a negative DMC ratio (debt minus cash flow). This gives you an idea of companies with strong cash in the books.
Being debt free in the Indian context
If you add up the market cap of debt free companies and insignificant debt companies (debt less than 25% of net worth), they account for 65% of the overall market cap. These debt free or near-debt free companies account for 2/3rd of the market value although it is much lower in terms of sales or assets. That basically means rich valuations for such zero debt companies. This is due to the lower risk inherent in investing in these low debt companies.
The one risk in a debt-free company is the growth risk. For example, an investor may not make money in a debt-free company due to weak growth but there is little chance of losing money. That itself is worth a lot. Also, these companies report higher return on equity and do not depend on outside sources of funding to launch new products or enter new markets. This shows in the valuations ratios of these companies. In India, an average debt-free company is valued at nearly four times its latest 12-month revenues and 28 times its annual profit. The myth is that all debt free companies are from IT and FMCG. That is not the case. Companies like Shree Cements and Hindustan Zinc are also debt free companies. There is a huge pick available and the choice is yours.
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