#2 Critical Financial Ratios To Avoid Investing In Indebted Companies
People think investing is a game of making money. Yes it is. But before that it is a game of protecting money. Why do I say so?
Because I believe that it is easier to find the right stock by eliminating wrong stocks from your watchlist. As Charlie Munger quoted ” All I want to know is where I’m going to die, so I will never go there”.
Avoid the pitfalls and you will survive the market. Once you survive the game you become better at stock picking. It’s that simple.
What if I give you two financial ratios and an additional parameter that can save you from disastrous investments in stocks like Reliance Communication, Jai Prakash Associates or Coffee Day Enterprises
The objective of this post is to focus on the leverage ratios that can help you identify companies which are taking too much debt and may go bust sooner or later. And guess what? You really don’t need to break your head with financial statements as they can be very intimidating, lengthy and boring for quite a few of us.
So we will use two very simple financial ratios. They make our lives easier. You need not be from a finance background to weed out bad companies.
Please note that these ratios may not give you the right picture to analyze banking companies or non-banking finance companies. Such lending companies require other additional financial ratios to identify pitfalls.
This post is about identifying businesses that borrow money from lenders. For example, Reliance Communication borrowing from SBI or Bank of Baroda.
In today’s post, I will share 2 financial ratios and another bonus criteria to help you avoid stocks of companies in which you should not even think of investing. And off course there will be examples to understand better. Let’s begin then.
Table Of Contents
Leverage is the use of borrowed money (debt) by companies for purchasing assets, expanding their operations, or other purposes. Firms can raise debt by borrowing money from banks or other sources like bonds. Every debt payment has to be repaid along with an interest.
Now Debt in the hands of a company which can generate a much higher return on the borrowed money than the cost of interest payments is a good thing. It is the other way round where problem arises.
For example, your firm borrows money from the bank at 10% interest per annum but your company is able to generate only 5% return on the available capital. Such a firm will have to borrow more next year as it generates less return on the capital.
Usually there are certain sectors like Airlines, Real Estate or commodity manufacturers like sugar, steel etc. Companies from these sectors operate in a very competitive environment and do not make enough money. The result is that they have to keep taking more debt just to survive another year and repay the previous debt. It’s a vicious cycle.
As an investor we have to avoid investing in such companies which borrow a lot of money and then are unable to repay their debt.
We will be covering two leverage ratios namely, Interest coverage ratio and Debt To Equity Ratio. There is one more parameter apart from these two that will be covered as well. So stay tuned.
Interest Coverage Ratio
Can you cover your interest payments? That’s the question this ratio addresses. Suppose a company takes a loan with an annual interest payment of 50 lakh Rs and its income is only 40 lakh Rs. What is it going to do to address the shortfall of 10 lakhs in interest payments? Beg, borrow or steal? May be.
There is another possibility. It can go bankrupt. That’s right. If you can’t make enough money to repay your loans you are going down for sure.
Essentially Interest coverage ratio helps us understand how much the company earns with respect to its interest payments. It is calculated as per the following formula
Interest Coverage = Earnings Before Interest and Taxes (EBIT) / Interest Payment
Don’t be overwhelmed. You really don’t need to calculate it. You just need to know how to use this ratio. In case you want to know more about EBIT, you can click here.
So an Interest Coverage Ratio of 4 means that a company’s Earnings Before Interest & Taxes (EBIT) is 4 times its interest payments.
How To Use Interest Coverage Ratio?
1. Avoid companies with interest coverage ratio less than 3. The higher this ratio, higher the ability of the firm to meets its interest payments.
A low ratio indicates a high probability a company will not be able to meet its debt obligations whereas a high ratio implies sufficient earnings available to service its debt repayments.
Firms with low interest coverage ratio also find it difficult to borrow capital and if they do, the interest rates charged to them may be higher.
In fact in times of economic distress (recession) we should look for debt free companies having much higher interest coverage ratio of 10 or more.
Time for an example now.
Let’s look at Coffee Day Enterprises Ltd (CDEL). As per the data from moneycontrol below, (CDEL) interest coverage ratio has been continuously below our safety level of 3. As of 2019, CDEL’s interest coverage ratio is just 1.06. You can say that it has improved from .57 in 2015 but still it is below our threshold of 3.
We will see more data on CDEL in sections below. For now my first ratio has indicated to stay away from this company as it has a high chance of not being able to repay its loans.
We will see a bit later how to find this ratio or other ratios in moneycontrol
Debt To Equity Ratio
Debt and Equity are two ways a company can raise capital. Debt represents borrowing money which needs to be repaid after a certain time along with interest payments from a lender like a bank. Whereas, equity means that you raise capital by parting with a portion of ownership in your firm.
By issuing debt you just borrow money but do not part with ownership in your firm.
The debt to equity ratio does a simple comparison of the total capital borrowed from lenders versus the total capital contributed by shareholders
Debt To Equity Ratio (DE Ratio) = Total Debt / Total Shareholder’s Equity
Again. Do not get overwhelmed by terms like Shareholder’s Equity. For now just know how to use the ratio.
Consider a company with total debt as 24 crores while total equity capital as 20 crores. It’s DE Ratio will be (24/20) which equals 1.2. So a DE ratio of 1.2 implies that the company’s total debt is 1.2 times total equity capital.
How To Use Debt To Equity Ratio
1. Ideally, one should avoid investing in companies with a high DE Ratio say >= 1.2
But this cannot be a benchmark. Combine this information with steps 2 and 3 below to take a call whether to invest or not in a stock
2. Along with a high DE Ratio, you should also check if the DE Ratio is increasing for a company over a period of time (say 3, 4 or 5 years). If yes, then this may not be a good sign as it signifies company borrowing more money as compared to the equity capital it has. Let’s look at an example here.
3. Combine the interest coverage ratio with the Debt To Equity ratio to check if the company passes our criteria for it to be a good investment
(Interest coverage > 3, Debt To Equity <= 1.2 and Debt To Equity not increasing)
Coffee Day Enterprises Debt To Equity Ratio
Let us see what the DE ratio looks like for Coffee Day EnterprisesLtd (CDEL). As per the data from moneycontrol, DE ratio of CDEL as of Mar 19 is 2.59. This implies that company has borrowed a lot of money as compared to its equity capital.
A DE Ratio of 2.59 is much higher than our threshold value of 1.5 but as we said we should also check if this ratio has been increasing or decreasing over a period of time.
Therefore looking at the trend (ignoring DE ratio of Mar 2015 = 6.5 as company was not listed on stock exchange until 2016), we see that DE Ratio from Mar 2016 to Mar 2019 has increased from 1.47 to 2.59. This suggests that company is borrowing more money as compared to equity capital.
Therefore company’s DE Ratio is > 1.2 and is increasing over time. Now we also saw earlier that CDEL’s interest coverage ratio was only 1.06 as of Mar 2019 which is less than our recommended value of 3. Therefore Coffee Day Enterprises Ltd. fails the test criteria and should be avoided as an investment.
Wait. There is more to the story. Along with Interest Coverage ratio and Debt to equity ratio there is one more thing that is a sure shot sign of company going bust.
Is The Promoter Pledging Shares
Promoters usually have significant shareholding in their own companies. Sometimes these promoters may be in need of money and may want to raise capital for personal reasons or for funding related to the company.
So they approach a lender like a bank. The lender will keep the shares belonging to the promoter as a collateral and provide him/her with a certain agreed amount as a loan.
Just like banks may keep your property or jewellery as a collateral against the loan, the shares are a collateral for the bank against the loan given to promoters.
This my dear friends is called pledging of shares by promoters.
Pledging Of Shares, A Risky Game
Stocks are volatile by nature. They keep changing every now and then. Consider a promoter who wants 20 crore rupees for raising funds for his firm. He walks to a bank of his choice and offers his shares as collateral.
Now at the time of creating the pledge the value of collateral is 20 crores but as you know shares can bring nasty surprises. 2 days later the stock of the company falls 20% and so the collateral value of shares pledged with the bank is now reduced by 20% to 16 crores.
In such case promoter has to bring additional cash to cover the shortfall or pledge more shares. If the promoter is unable to cover the deficit the lender can just sell his shares. As this post is not about specifically about pledging of shares I do not want to over complicate things.
I think this fairly conveys the idea that pledging of shares can be a risky venture for promoter and shareholders alike.
When & Why Is Pledging By Promoters A Sign To Be Cautious
I usually stay away from companies where promoters have pledged more than 10% of their holding. In fact I usually pick up companies with zero pledge. After all if the company is doing well why should I as the owner of a company go and pledge my shares. In the field of investing opinions can vary but I have never been comfortable with pledging of shares
If you seen an instance where the promoter holding is pledged to 10% and then keeps increasing gradually you better get out of such an investment.
Let us now come back to our case study of Coffee Day Enterprises Ltd. (CDEL). As per below data from moneycontrol we can see that the promoter has pledged 79.94% shares as of Sep 2019.
Time To Put Our New Found Knowledge To Test
Now let us say its 12th Feb, 2019 and you are an investor who thinks Coffee Day Enterprise is a great business. I have seen the Cafe coffee day stores running well. People spending quality time while sipping coffee. This stock should definitely do well. That’s the subjective idea which our minds cook up all the time.
You check the price on 12th Feb, 2019 and Coffee day enterprises is trading at 250 – 254 Rs a share. You think that the stock has been falling for sometime now from 300 to 250) so it may be a good time to buy it.
But you thought of being a wise investor this time. You decided to check the pledging of shares on moneycontrol website. By looking at the data (as shown in previous section) you came to know that the promoter had already pledged 79.36% of their shareholding as of Dec 2018.
Boom. Just by looking at this data in Feb 2019, you realize that this company could be a ticking time bomb and it is better to avoid investing in this company at a share price of 250 Rs.
So would you have taken the right decision by not investing? Definitely Yes.
You know where the stock trades as of 3 Jan, 2020?
Finding Data On Moneycontrol
Before we end this post, I will provide the steps to find interest coverage ratio, debt to equity ratio and promoter pledging on moneycontrol. You can also use any other website of your choice.
1. Go to moneycontrol.com and search for the name of Coffee Day Enterprises. Select Coffee Day Enterprises from auto suggest as shown below
2. Once you land on moneycontrol page related to Coffee Day Enterprises, you will have the option to either select Financials tabs or Shareholding tab as shown below. Use the financials tab to further navigate to ratios and if you decide to see the promoter pledge details then select Shareholding tab
3. Assuming you selected the financials tab. Select the Ratios tab as shown below
4. Once you select ratios tab, you will be able to see all the financial ratios related to Coffee Day Enterprises as shown below. One thing to remember is to select the consolidated tab instead of standalone once you are on this page.
5. If you select the Shareholding tab then you should see the pledge shareholding details as shown below
Before we end, we will do a quick review of what we need to look for to avoid bad investments.
1. Interest coverage ratio should not be less than 3
2. Debt To Equity ratio should ideally not be higher than 1.2 but this cannot be the sole point to reject a company.
3. If Debt to equity ratio is > 1.2 and is also increasing every year then it is a sign of concern
4. Promoter should not pledge more than 10% of his shares and if the pledge is increasing above 10% please get out
5. You can also combine interest coverage and debt to equity ratio with profitability ratios to segregate stocks of sound financial companies from poor performing companies.
I hope you liked the post. I will be more happy if sometime in the future the parameters discussed in this post save you from making a bad investment and you come back to comment and share your views with the others.
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Disclaimer: Stocks mentioned in the post are only for tutorial purpose. Author does not recommend any stock. Please do your due diligence before investing.
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