Analysts and investors like stocks of debt free companies. Why? Because in the process of intrinsic value estimation of stocks, debt plays a decisive role.
[Check list of top debt free companies at the bottom of this post]
In this blog post we will try to see the debt of companies through the lense of intrinsic value. Sounds interesting, right? But what does it mean, and how will I go about it? To understand this, one must first know about two things:
- Types of debt: What type of debt a company can avail? There are two types of debts visible in companies balance sheets, (a) Short term debt (current liability), & (b) Long term debt (non-current liability). Know more about fundamentally strong stocks.
- Why company avail debt: Companies generally resort to short term debt to manage their immediate cash flow needs. Short term debts give liquidity to companies working capital (WC). Long term debts are availed more for the purpose of CAPEX. Know more about if debt is good or bad for companies.
Both the above type of debt effects the company’s intrinsic value in their own way. Let’s know more about it.
[Learn to estimate intrinsic value of stocks using my stock analysis worksheet]
1. How short term debt effects intrinsic value?
Which debts are of short term in nature? Those debts, which the company will settle within next 12 months from the date of borrowing.
Short term debt does not negatively effect the intrinsic value a lot. How? To understand this, let’s know a bit of maths about intrinsic value. Intrinsic value is dependent on free cash flow (FCFE).
Higher will be the free cash flow (FCFE), more will be the intrinsic value. Read more about free cash flow analysis. What is the formula to calculated FCFE?
FCFE = PAT – [Capex – D&A] – Increase in WC + (Net LT Debt).
How short term debt effects this FCFE equation? Short term debt will have two effects:
- Effect on ‘Increase in WC’: When companies takes short term loan, its cash balance in the balance sheet increases (current asset). Simultaneously the current liability side also increases by the same number. Why? Because this loan must be paid back in next 12 months. Increase in working capital equals Increase in CA – Increase in CL. Hence due to short term loan, there will be no increase in working capital.
- PAT: PAT is Profit After Tax (Net Profit). Short term debt will reduce PAT by a small amount. Why PAT will reduce? Due to increased “interest” expense. But as it is a short term debt (period <12 months), additional interest expense will be too small.
The overall effect of short term debt on FCFE (hence intrinsic value) is only marginal. Looking at the formula, PAT is decreasing (marginally) but the balance items remains as it is.
This means, there is no major reduction in FCFE due to short term debt. Hence intrinsic value is not greatly effected by short term debt.
[Note: New Debt – Debt Repaid, talks only about long term debts]
1.1 Debt free companies and short term debt.
How does the above analysis on short term debt compliments our topic of “debt free companies”? As free cash flow (FCFE) is only marginally effected by short term debts, hence its impact on intrinsic value is also small.
So does it mean that a company can take as much short term debt as it wants? Never. If the level of short term debt crosses a limit, it might lead to problems in repayment.
How to define this limit?
Short term debt / Cash and Cash Equivalent < 1Formula_1
So if a company satisfies the Formula_1, it can be treated as good as a debt free company.
2. How long term debt effects intrinsic value?
FCFE = PAT – [Capex – D&A] – Increase in WC + (Net LT Debt).
The impact of long term (LT) debt is more visible on intrinsic value of a company. Why? There are two reasons for it:
- Impact on PAT: Generally speaking, compare to PAT, LT debts are bigger in size than short term debt. Hence the impact of “interest expense” on PAT is more significant.
- Impact on FCFE: LT debt directly increases the FCFE (see the below FCFE formula). The net effect of LT debt is that, it always increases the FCFE.
To understand the effect of long term debt on free cash flow (intrinsic value), let’s see a hypothetical example.
Suppose there is company whose net profit (PAT) is say Rs.4,108 Crore. If this company avails a long term debt of (LT debt) = Rs.24,568 Crore. Its interest expense @8% will be Rs.1,965 Crore.
- Impact on PAT: It will be reduced to Rs.2,143 Crore (4,108 – 1965).
- Impact on FCFE:
- FCFE before LT debt (LT debt = 0): FCFE = 4,108 – (Net Capex – Increase in EC) + 0 = Rs. (4,108 – K) Crores.
- FCFE after LT debt: FCFE = 2,142 – (Net Capex) – Increase in EC + 24,568 = Rs. (26,710 – K) Crores.
What we can understand from this example?
LT debt can significantly increase the free cash flow (FCFE), irrespective of its negative effect on PAT (reduced PAT).
2.2 Debt free companies and long term debt.
How does the above analysis on long term debt compliments our topic of “debt free companies”? The above FCFE calculation shows that, the bigger is the LT debt, higher will be the FCFE.
But does it means that a company can take as much LT debt as it likes? Never. Too much LT debt will make the firm too susceptible to bankruptcy. LT debt must not cross a safe limit. What is that limit?
To identify debt free companies, I use the below three (3) screeners:
- Formula_2.1: Total Debt minus Cash < 0 (negative). Use of this formula will supersede the formula_1.
- Formula_2.2: Total Debt / Equity ratio < 0.25.
- Formula_2.3: Total Debt / Total Asset < 0.20
What we can conclude from this analysis?
A company which satisfies the above 3 formulas are as good as debt free companies.
They may not be a zero debt company, but their debt level is so low that they can still be treated as a “debt free company”.
3. Example of Debt Analysis of a Company
We take a small hypothetical example of two companies and do its debt analysis. Suppose there are two companies ABC & XYZ. Just note how the debt of these two company is compared systematically.
- Absolute Debt: ABC has a debt of Rs.80 Crore and B has a debt of Rs.120 Crore. Which company looks better here? If we have to look only at debt, Company ABC looks less risky, right? Read more about stocks which value investors avoid.
- Debt Equity Ratio: Now suppose, Net worth of ABC is Rs.80 Crore and Net worth of XYZ is Rs.120 Crore. Means, the debt equity ratio (D/E) of ABC is 1 (80/80) and that of XYZ is also 1 (120/120). So which company is better? Debt/Equity ratio is not able to differentiate between ABC & XYZ – both looks the same. Read more about employed capital (equity + debt) of stocks.
- Cash Reserves: Suppose Company ABC and XYZ has a cash/cash equivalent reserves of Rs.75 Crore and Rs.132 Crore respectively. Debt minus Cash for Company ABC is Rs.5 Crore (80-75). Debt minus Cash for Company XYZ is Rs.-12 Crore (120-132). A negative value for Company XYZ indicates that company is having enough cash to pay-off all its debt.
Hence, even if companies like XYZ is carrying high debt (Rs.120 Crore), they are still as good as zero debt companies. Why? Because XYZ also has enough cash reserves (Rs.132 Crore) to negate its debt burden.
Such companies (like XYZ), whose Debt minus Cash value is negative, can be included in our list of debt free companies. How to calculate debt minus cash for a company? Use this formula:
Enterprise Value minus Market Capitalisation = Debt – Cash
Know more about how to calculate enterprise value here…
Example: Ideally we consider those companies as debt free whose D/E ratio is zero. But in the below list of companies you will see MRF and SJVN whose D/E ratio is 0.22 and 0.21 respectively. They have still been included in the list because of their negative “Debt minus Cash” component.
List of Top Debt Free Companies in India – 2019