Prof. Prashanta Chandra Panda & Prof. Manoj Jena, January 16, 2016 : Dealing with Stock Exchange and be a part of it is surely exiting. But one has to have basic knowledge of some of the financial ratios and understanding of their relevance in analyzing a company’s position in the market among its peers. A good grip on various ratios such as Debt to Networth ratio, returns on investment, profit margins, price to earnings ratio and percentage growth of these factors with time add to significant understanding about the company’s health in the financial market. Importance of debt and the comparative debt position related to the company’s financials are discussed in this section.

Image 01When we talk about Debt of a firm, we can divide them to borrowings from government and semi-government financial institutions (2) borrowings from banks against own debentures and other mortgages, and (3) other borrowings against own debentures, other mortgages, deferred payment liabilities and public and other deposits. Individual industries growth rates influence debt levels in their capital structure. However we have to see the link between operating leverage (asset acquisition activities) and financial leverage (associated with financing activities). It is mostly seen small size firms comparatively have higher debt to equity ratio than the large size firms.

Financial risks for a company can be read from its leveraged position. That means how far the company’s asset is stretched financially. It is quite normal that when your time is good you can have more loans to finance your growth. The debt ratio is defined as the ratio of total – long-term and short-term – debt to total assets. A better indicator could be the Debt to net worth ratio which indicates whether the company’s equity (shareholders’ equity +reserve) position is adequate compared to its borrowings. Off course companies need debt for running and augmenting the businesses further. Higher debt with respect to the company’s equity should proportionately reflect in business expansions and consequently extra revenue and profits. This leverage or debt financing is an important tool for companies to source funds to grow. You cannot blame them as long as additional business generated make debt sustainable. If you are in a market where the rate of interest is low (5% or less) then this option is more preferable. If you have a projection of 15% or more growth in profit or even revenue you may find 7 to 9 % rate is attractive. If there is a quick turnaround in fortunes or additional business generation is possible in one to two years time then you can convince investors and opt for equity finance for the expansion or even consolidation of your position.

Knowing the sectors in which company operates one can position its views while commenting on the financial risks the company may bear because of its debt position. We mean to say here that if company A has total equity of Rs. 1000 crores and total debt of Rs. 250 crores i.e. debt to equity ratio of 0.25 (25% ), itself alone may not be a better indicator to compare the financial position. Another company B with a debt ratio of 60% could be performing better in a different sector. As discussed earlier this ratio could be useful to compare the peer companies in a particular sector. If both are facing tough times and seem to be in the same sector then the B Company will have more difficult time to raise further loans. A positive goodwill and higher accounts receivable may compensate capital market precautions to some extent for the B organization. Nevertheless it is important to assess a company’s ability to repay the loan and the impact of borrowings on its bottomline.

Capital intensive industries like railways, airlines, oil drilling, production and refining; telecommunications, mining, chemical plants, and electric power plants require large amounts of expensive equipment and raw materials to make their products. Port and harbor, water supply, airport and infrastructure construction sectors also have large capital requirement. HugImage02e sunk costs, long gestation period, slow returns; dependency on national growth has significant impact on these businesses. This sector is also subjected to state regulations in fixing prices, sensitive to political environment and policy changes. They need lot of money to keep operations going. More capital is also required for productivity growth. Hiring of efficient  labour force is also important here.

Big companies selectively sell the non-performing assets and use the funds for the core businesses which perform better. Otherwise the cost of this debt financing can outweigh the returns that the company generates. Consequently this negatively affects stakeholders’ values in the long run. You find some of these industries have debt/equity ratio above 2. Fall in prices and small growth in demand affect them badly. There is a withdrawal tendency once investors find them in radar. However, the winners maintain a healthy balance sheet with respect to the debt equity ratio, deploy capital strategically for better cash flows, and establish better governance for the growth and subsequent value addition of their businesses.

From economic stand point other big handicap could be the non-tradability of the services produced by the above industries. So your market is limited and you cannot have any export market. Here you are dwelling on a service which is crucial for human development. Search for pareto optimality puts service provider in a difficult situations. So these industries need additional guaranteeing such as: exclusive government ownership or public private partnership, terms of pricing, contract for accountability. Sea ports, air ports need more funding to raise the volumes of transactions from their facilities. These industries are highly impacted due to frequent demand fluctuation or a policy change. Their efficiency to deal with this change in the demand may be considered as one of the parameters of research.

Borrowings are certainly important for the running and growth of businesses. However; as it is discussed above this must reflect on the revenue and botomline of the company’s financial statement. The company while accessing to the debt through various instruments, it must maintain the debt to equity level within reasonable limit for the sustainability.

(This article is in continuation of the article on “Travel some journey before you enter the Exchange” published on December 21, 2015,