Playing with debt

We have published several stories in the past about the dangerous levels of debt of the Indian listed companies and its various aspects. This time we have analysed a very simple approach to get the idea of the debt situation of a company: the debt-to-equity ratio. The debt-to-equity ratio of the Indian listed companies is currently at a dangerously high level.

We have found that around 403 companies have debt-to-equity ratios of more than three, which are very high as compared to the normal figures. These 403 companies account for almost 16 per cent of the companies listed on the Bombay Stock Exchange, excluding around 500 banking and finance companies. The number of companies with a debt-to-equity of more than two and one are 567 and 1,017, respectively.

The debt-to-equity ratios are high, but to check vulnerability we looked at the return on capital employed of the 1,017 companies having more debt than equity. To pay off the liabilities, the companies' RoCE should be at least more than the cost of borrowings. Assuming the cost of borrowing at 11 per cent, to our surprise, we found that there are only 343 companies which have RoCE of more than 11 per cent. The second parameter to judge vulnerability is the interest coverage ratio (ICR), which measures the interest-paying capacity of firms. It also paints a gloomy picture. The number of companies which consistently have an interest coverage ratio of more than two in the past five years is only 115.

What should you do?
You should always stay away from companies with high debt and less margins to pay the interest. This wisdom goes for any investment and business cycle. One should avoid stocks with high debt-to-equity ratios, irrespective of the kind of industry they operate in. Even if you do invest in such a company, then ensure that it has an extraordinary ability to service its loans. To find such companies, we ran a screen with debt-to-equity ratio of more than one and a high RoCE and interest coverage ratio (see box for the detailed criterion). To our surprise, in such a huge universe of companies, we were able to get only nine names (see the table).

Bases of our selection

• Debt-to-equity ratio > 1
• Current RoCE > 20%
• Average RoCE in past five years > 18%
• Last five-year ICR > 2
• Current ICR > 3
• Market cap > ₹500 crore