Facts about “Stock Debt”

You may have come across the term “Debt”. You would be thinking or may have over heard from others that companies or stocks with zero debt is so much desirable & has got chances of continued growth. Well then let me clear it out, the debt is not that bad after all! Wonder why? Let me decode it for you.

Debt is nothing but the short or long-term borrowings of a company to fund/ finance his business capital needs. If a company is utilizing the capital of the owner/ promotor for its business needs or further expansion, the owner would expect atleast double the lending interest (interest levied on the borrowed amount/debt) on his capital. But if you are utilizing the funding from debt whose interest is half of the expected return of the owner’s capital, the debt funding s cheaper!

Always in a balance sheet, the short-term debts must not be utilized to finance the long-term debts, but vice versa is perfectly fine, ie. the long-term borrowings can be utilized for paying off the short term debts since the long term debt, as the name suggests has got longer time/ duration to pay off unlike the short term debts.

However as per warren buffet, a debt to equity ratio if 0.5 is always desirable to pick a stock. But in Indian scenario a debt to equity ratio as high as 1.0is acceptable provided its net current assets are more than its total debt, so that it can clear the debt by liquidating its current assets.

Leverage Analysis

The word leverage has been derived from the word “lever”, which as you know is an engineering term. By using a lever it is possible to lift greater weights by exerting less effort. The lever works on the principle of fulcrum. Similarly, when a highly leveraged organisation increases its turn over by a certain percentage, its profit increase by a larger percentage. The fulcrum in such cases is the fixed cost. When fixed costs are higher, the impact on profit is greater. Fixed cost & variable cost I will explain in detail on my later post. For now to simply it further, company can generate more profit & hence earnings per share if it is able to achieve larger sales volume, leveraging on its debt. Like that the company is utilizing this borrowed money or debt for doing business & contributing to the company bottom line (Note- Bottom line means profit and Top line means Sales).

One of the best books depicting this beauty of leverage analysis is Mr. Anil Lamba’s “Romancing the Balance Sheet”, which is a recommended must-read book in my list.