Lowering DEBT Leads To Better Performance

Lowering DEBT Leads To Better Performance

Debt is a perfect example of the proverbial two-edged sword. The clever use of leverage can boost the returns a company generates for its shareholders to a large extent; however, it is difficult to carry a large amount of debt successfully in a tough economic condition. Lately, we have seen a number of companies lowering their debt levels. Join us as we go about finding out what is the right capital structure and analysing the performance of certain companies that have moved away from debt 

For a business to continue to be successful, it has to invest in new plant and equipment to generate additional revenues. This is the fundamental basis for driving future growth. Finding sources for funding is perhaps one of the most important decisions the management of a company has to take to finance its assets, day-to-day operations and future growth. From a tactical perspective, the capital structure of a company influences everything from a firm’s risk profile, the return its investors expect and its degree of insulation from macroeconomic factors.

One way to pay for these investments is to generate capital from the firm’s operations. The earnings a firm generates can either be distributed as a cash dividend or ploughed back into the firm. But more often than not, the retained earnings of a firm are insufficient to support profitable investment opportunities. In that case, a firm is faced with a decision: to raise new capital either by borrowing (incurring debt) or by selling additional ownership (equity). The combination of the two used to finance a company’s projects is called the capital structure. Hence the capital structure of a firm is a mix of debt, internally generated funds and new equity. But what is the right mixture?

There are several theories that can help one gain insight into this question. One of them is the ‘Pecking Order’ theory which stems from the concept of asymmetric information. This occurs when one party possesses more or better information than the other. In this case, the management of the company possesses more information than external users such as creditors and shareholders. To compensate for this lack of balance, external users will demand a higher return to counter the higher risk they undertake. The company’s internally generated funds come from the company itself and hence the information asymmetry here is negligible. As such, these funds should be the first choice of financing.

A higher return is demanded when companies need to finance externally through debt or equity because the creditors and investors posses less information of the company than the managers. When it comes to picking between the two, debt is preferred over equity simply because it is cheaper. Thus, the Pecking Order theory suggests that the first choice of managers is the company’s internally generated funds, and if external funds are required, the firms should issue debt first and only use equity as a last resort. This explains why profitable firms have low debt ratios – not because they have low target debt ratios, but because they don’t need to obtain external financing.

Does this mean that the management should always prefer debt over equity when financing funds externally? Certainly not! There is no denying that having debt on the books brings about certain advantages. Besides than just being a cheaper source of finance and amplifying returns on investment, debt financing enables the promoters to maintain control as it does not dilute ownership, unlike equity. Having debt on the books even acts as an antidote to complacency since managers have to ensure that the investments they make will earn at least enough return to cover the interest expenses and hence are forced to be disciplined. Moreover, there is also the effect of tax shield which is essentially a reduction of taxes brought on by deductions to taxable income from a company’s interest rate. However, despite its many advantages, the management has to be cautious in using this form of financing.

This is because of the risk that employing too much debt brings along with it, which is also known as the cost of financial distress. The most significant danger and disadvantage of using debt is that it requires repayment, no matter how well the company is doing, or not. A new company might be burning cash for the first couple of years with little in the way of net profits, yet still has to make monthly debt service payments, and this can be a huge burden. This can be an even bigger problem when during periods of economic turbulence the top lines of companies are strained. Indeed there have been cases where taking excessive levels of debt have brought companies to the brink of bankruptcy.

Case Study: Suzlon Energy

In the early 2000s, ‘green investing’ caught the fancy of investors worldwide as they realised that being environmentally conscious could be financially rewarding too. There was a lot of attention on Suzlon Energy’s Initial Public Offering (IPO) in India in September 2005. When the IPO closed, the issue was oversubscribed by nearly 25 times and began trading on the exchanges at a premium of 35 per cent to the issue price of Rs. 510. In the following months after the listing, the stock went on to touch record levels. On October 23, 2007, Suzlon Energy split the face value of its shares from Rs. 10 to Rs. 2, and the shares started quoting on an ex-split basis from January 21, 2008.

The company’s stock closed at its all-time high of Rs. 2,238.10 per share on January 9, 2008 or an adjusted closing price of Rs. 448, causing many investors who had not included the stock in their equity portfolios to look back with a sense of regret. Buoyed by the hugely successful listing, the company took to the strategy of fast inorganic growth. As part of this strategy, the company went on acquiring a string of high-profile targets including Belgium-based Hansen Transmissions International in 2006 for USD 565 million and Germany-based Repower (renamed Senvion) in 2007 for USD 1.6 billion, outbidding France’s Areva. These acquisitions were financed largely by debt and earned the promoter a reputation for careless expansion.

Through these two big-ticket acquisitions, Suzlon Energy hoped to secure superior technology and talented management which would propel the company to be a market leader. This strategy worked to some extent. It put Suzlon Energy on a pedestal, making it the fifth-largest wind turbine company in the world. However, in its pursuit of fast growth, the company failed to take into account several sources of risk. It was submerged in excessive and costly debt on its balance-sheet by acquiring companies bigger than itself, and tried to capture new markets with new products, all the while compromising on quality and customer service.

In the days before the financial crisis of 2008, demand had raced ahead of supply. Aided by government incentives for wind power generation and huge orders, the company started building wind blades without waiting for orders. This proved to be a costly mistake because come 2008, the narrative for Suzlon Energy began to change quickly. Orders began to shrink and inventory started piling up. There were reports of high cost incurred in fixing manufacturing defects and for compensating customers for cracked blades.

Further, a slowdown of demand in Europe and the US and delay of payments from customers amidst the global economic downturn meant that Suzlon Energy found itself staring at a financial crisis. Its share price fell from a high of Rs. 448 on the Bombay Stock Exchange (BSE) on January 9, 2008 to about Rs. 35 in a matter of 14 months. Today, for a host of Indian companieswaiting in the wings, Suzlon Energy is a cautionary tale of a company that chose the path of rapid growth without factoring in the big risks that come attached to it. 

"The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money"

Warren Buffett in an annual letter to Berkshire Hathaway shareholders in 2008. 

A Lesson Learned

In the years since, many companies have been playing it safe with lower or reducing levels of debt and have even tended to outperform in the market. Some of the companies that have created a lot of value for shareholders are virtually debt-free like Infosys and TCS. Many debt-free multinational companies such as Bosch, Siemens and Oracle have performed well in the global markets. There have been companies in the steel, infrastructure and real estate sector that have outperformed the market only after they started downsizing their debt. DLF is a good example in this regard.

According to government sources, the top 50 corporates in the country have reduced their debt levels by around Rs. 59,600 crore in the first half of the fiscal year 2020 as part of their strategy to deleverage their balance-sheet. In the previous financial year, these companies had reduced their debt burden by about Rs. 43,000 crore. These firms now prefer to raise funds through alternative investments like external commercial borrowing (ECB) since it is available at a comparatively lower cost. Further, the legal framework, including the Insolvency and Bankruptcy Code (IBC), has also been prompting companies to reduce their dependence on debt. This begs the question as to how companies that have reduced debt levels have performed and how their performance has translated into stock returns.

Empirical Evidence

We have considered all the companies listed on the Sensex BSE 500 for this study and have picked those that have been decreasing levels of total debt on the books continuously since 2016. Most of the companies that fit the bill showed an increasing trend in PAT levels over the years. Out of these companies, Delta Corp, Mahanagar Gas and NOCIL were among those that become debt-free during this period. Out of the 21 stocks, 18 showed positive four-year annualised returns – many of these returns came in double digits.

Himadri Speciality Chemical, Balkrishna Industries, Radico Khaitan led the way in terms of stock returns, giving returns of 71.05 per cent, 66.87 per cent and 64.55 per cent respectively. In the short term, however, the one-year return for these companies was mixed with 10 companies showing negative stock returns out of the 21 companies, reflecting the consumption slowdown that has gripped the country lately. Despite the slowdown, companies such as Relaxo Footwear, IPCA Laboratories and Vaibhav Global gave stock returns in excess of 50 per cent.

Conclusion

We know that companies in the infrastructure and industrial sector require huge investments and debt is almost inevitable in these cases. On the other hand, IT companies are mostly debt-free and have huge cash reserves but are light on assets too. Hence, debt levels alone cannot be the lone deciding factor in investing. That being said, there is nothing better than a company which can meet its plans for expansion from its own internal funds. Companies which are committed to lowering debt levels in the long term also prove to be good investment opportunities as they are relatively better off during times when the business environment faces a downturn.



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