In an ideal world, a company is expected to generate higher returns for its shareholders. And if investment opportunities are limited, it is expected to distribute the excess funds in various forms, such as dividends to its shareholders. However, at times, companies loan some of the excess funds to their related parties.
As the name suggests, the related party refers to a person or entity that is related to the company. These include associate companies, subsidiaries, trusts and key management personnel. Owing to their close proximity or business relations with the company, at times, these are able to receive high advances which may or may not go in favour of the company's shareholders. While not all related-party transactions are suspect, an investor should still keep track of them. Check details like the purpose of the loan, interest rate charged, etc., to ensure whether these loans make any business sense to the lending company.
In the accompanying table, we zero in on five companies that have offered advances of more than 10 per cent of their total assets to related parties and in some cases, more than 40 per cent. If any of these related parties defaults on these advances, that may significantly impact the company's financial position. Let us look at these transactions individually:
GOCL Corporation: It provided a loan of $150 million to its subsidiary HGHL Holdings for a downstream joint venture payable in seven years at a rate of USD Libor (London Interbank Offer Rate expressed in US dollars) plus 570 basis points per annum.
Wardwizard Innovations: Details of loans not provided
Jet Airways: The company had an outstanding balance from its wholly-owned subsidiary Jet Lite to a tune of `2580 crore. However, the company has classified the loan as doubtful in its last annual report.
Gujarat Fluorochemicals: The company has paid advances towards the purchase of assets even before their acquisition.
Jindal Stainless (Hisar): The company provided an inter-corporate deposit to Jindal Stainless, one of its associate companies. However, its interest servicing for FY19 and FY20 has been deferred until February 2021 following a mutual agreement between two entities.
Thus, investors should be particularly wary of companies that offer large loans to their related companies, especially at unfavourable terms, which may ultimately result in the erosion of shareholders' funds.