How A Company's Debt News Influences Its Stock Price

UDAYAN RAY: Mohit, companies have to raise money. They can either do it through fresh issue of shares or through some kind of a loan or debt. Finance students would call this the capital structure. When a company says that it is raising debt, what should the investor be looking at?

MOHIT SATYANAND: I think you need to look first at what is the kind of return on capital employed that a company makes. If the return on capital employed is higher than what the company is paying for its debt, then it’s a positive thing because the difference is going to become return to the shareholder, right?

So as Udayan said, most companies do raise debt in order to expand. I think the danger signals are, number one, if you raise too much debt, you become vulnerable to fluctuations in the economic cycle. And the number or the index that helps you decide this is what is called the debt equity ratio. It’s a number that you will find on most analyses of a company. It’s very difficult to say that this is the number at which you should get worried because companies which are in the infrastructure space, for example, tend to have very high debt-equity ratios. They can be as high as 6:1. But that’s precisely why these companies become very vulnerable to economic slowdown.

Personally I start getting a little worried when debt equity ratios run over 2:1. But I think every time you do look at debt equity ratio, you need to remember to go back to what is return on capital employed on this company historically.

UDAYAN RAY: So Mohit, when you’re talking about return on capital employed, let’s try to break it up into two parts. One is the capital employed. So that means if I were to be a company, I have distributed shares, so that’s one part of the capital. And if I’ve taken loans form people or companies it’s the other part (of capital). That’s capital right?

MOHIT SATYANAND:That’s right.

UDAYAN RAY: So, that capital has been employed in setting up the company and running it. And out of that capital, what is the return I am getting.

MOHIT SATYANAND: That’s right.

UDAYAN RAY: So this return on capital employed, people can get it (easily)….

MOHIT SATYANAND: Oh yeah, yeah, yeah. It will be there in ratios in most analyses. Whether it’s a moneycontrol or typically, a company will have it in its annual report. You can download the annual report from…

UDAYAN RAY: From say, a BSE or something….

MOHIT SATYANAND: Yeah, yeah, yeah. It’s all available.
It’s very simple. If on average a company has a return on capital employed of 25% and is raising debt at 15%, as a shareholder you should be very happy because you are going to make 10% for every extra rupee of debt that it’s raising. Unless it’s suddenly getting into a cycle which is a defeating cycle or you’re worried about it’s going into areas where you just can’t guarantee the return on capital. But I think to look at debt equity ratio as being something that worries you, in the absence of knowing what historically the return on capital employed, is being very foolish.

UDAYAN RAY: Well that’s a wonderful explanation. And well obviously Shakespeare isn’t working here in these – he said something like neither we are borrower or lender be. But that doesn’t really, really work.

MOHIT SATYANAND: Ha! Ha! Ha!

UDAYAN RAY: But in terms of a stock market investing, this is something that one needs to look at. When you’re into equity market investing or stock market or share market investing, you can choose whatever name you want to give. You need to be also very smart about what’s happening about companies’ borrowings.