Retail investors be cautious in selecting stocks with huge debt equity ratio

Leverage is defined as use of borrowing to increase the return to the shareholder. Higher leverage leads to higher financial risk which has its own issues. As example, when a company is levered and the economy cycle is not good or there is instability in the company / industry, leverage starts eroding the capital. We have many examples of companies where shareholder equity has turned to negative like HMT, Suzlon, Jet Airways, Spicejet, Shree Renuka etc.

Every businessman borrows money, when he is sure that he can earn at a higher rate of return and after some time repay the borrowing.  Few industries are heavily capital intensive and they depend on borrowed funds, few industries go through bad business cycles and are forced to borrow and sometimes government induces lending to certain sectors for their betterment. We also have companies which are averse to borrowing as they have huge business risk and they do not wish to borrow and add financial risk to their balance sheet.

We will focus on relationship between share price return and companies leverage and try to establish if companies which have huge borrowing are more successful than companies which do not borrow or vice-versa. Borrowing is reflected on the balance sheet under the head long-term borrowing or short-term borrowing. We will use the formula of book debt divided by shareholder fund to define ratio debt-equity ratio (proxy to leverage). We obtained data of top 1000 companies listed on BSE and NSE based on market capitalisation and applied the first filter of removing all financial companies and companies which did not have a continuous trading history from 2012. We were left with 780 companies.  We sorted all the companies on the basis of their debt-equity ratio of the latest financial year and divided them in 10 deciles. Each decile contains 78 companies. Since the companies are sorted in ascending order on the basis of debt-equity ratio and then divided in equal decile.  Decile-1 includes companies which have zero debt - equity ratio and decile-10 having shares of companies with highest debt to equity ratio exceeding 2.77 times, some companies which have eroded their share capital even have a negative debt-equity ratio. We obtained yearly share price returns and calculated median return in each decile for a meaningful comparison.

When markets are hostile, every business should try to minimise its fixed cost obligations. Cost can be segregated into variable and fixed, any kind of cost which changes with sales is referred to as variable cost and all other cost if fixed cost. Interest cost is not depended on sales of the company and hence is considered to be fixed cost. During bad economic cycles when sales of the company suffer, having a high fixed cost (high leverage) starts eroding the equity capital. All this is simple finance and now let’s look at debt-equity ratio and share price returns to see which set of company does better.

The return of S&P BSE SENSEX is negative 10% for the year 2015-16 and for a two-year period it is 8% (2014-16), these returns are not very encouraging.

Let’s compare the median returns of the ten deciles with the S&P BSE Sensex returns. If we look at the last one year return, Decile-7 is the best performer with median returns of 19% whereas the benchmark index has generated negative 10%. Decile -7 also has outperformed benchmark returns in all the years. Shares in decile -7 have a debt equity ratio in the range of 0.85-1.13.  Decile-7 has, 26 companies are from Industrial sector and 23 companies from the consumer goods sector. Companies in decile 1 and decile-2 which had the least amount of debt did not do as well as decile-7 but did better that the benchmark.

Companies in decile-10 performed the worst across all the other deciles, and they are companies which are having huge amount of debt on their books their debt equity ratio is above 2.77 times or negative.

Retail investors should be cautious in selecting stocks with huge debt equity ratio as the historical evidence suggests that they are laggards. In uncertain times retail investor should prefer companies with lower debt- equity ratio.