UDAYAN RAY Mohit, debt equity ratio, it is so much used and words like it can throw off a lay person. What does it say and what is it all about? And what should a lay investor be looking at when the word debt equity ratio is being used?
MOHIT SATYANAND Yeah this is a tricky one because companies do need to borrow money in order to grow typically, except for consumer goods companies. Companies in certain sectors need to borrow much more. Therefore, traditionally we have grown comfortable with infrastructure companies having much higher debt equity ratios. But I think at the end of the day what’s really important is to figure out whether the earnings of a company are large enough for them to service their debt. Because when you borrow money you have to pay a certain amount out by way of interest every year, unlike equity where you only pay shareholders if you actually make a profit. In the case of debt, banks are by and large not forgiving. That money has got to be paid every quarter. And these are obviously things that companies think about or should be thinking about before they borrow that money. And therefore it should be built into their finances.
But again I think it’s ratios like these are much more interesting in a dynamic sense than in a static sense. Which is that if you look at a company with a fairly high debt equity, let’s say, any company which has a debt equity ratio of more than 2:1. Then, I think before investing in that company you need to do a fair amount of research. You need to look at how that debt has moved over time. You need to look at whether the cost of finance as a ratio of the gross profit of the company has been going down or going up. If it starts going up, it’s likely to continue to go up for a long time and you are probably better off just exiting at that point in time. So again it’s not the number. It’s not the debt equity number. It’s just the fact that when the debt equity number is a little high, you need to make sure the company’s figured it out, that it’s managing that debt well, that it’s making enough gross profit to service it. In itself debt is not bad. As long as you figure it out in terms of your overall cost engineering of the company, and you are able to service that debt, and still have enough profit left over to pay the shareholder.
UDAYAN RAY Why is it being benchmarked to equity? What is the reason for that? Is it because you are the owner and you need to know for every unit that you own?
MOHIT SATYANAND It’s the same as for example my EMI.
MOHIT SATYANAND So an EMI of Rs 50,000 large or small? As an absolute number, it means nothing. If my annual income is Rs 2 lakh, a monthly EMI of Rs 50,000 is clearly unserviceable. If my annual income is Rs 50 lakh, an annual EMI of 5 lakhs is not so unserviceable. So equity is like that. But if the company has a huge equity base then it can service a lot more debt.
