High-leverage entities losing favour amid worries of corporate defaults

Investors looking to shift funds to firms with comfortable debt levels

Investors are leaving highly-leveraged companies amid worries of corporate defaults. Among BSE 500 firms, shares of those with debt-to-equity ratio of above one have fallen an average of 15 per cent this year. 

In comparison, the average share price fall for companies with debt-to-equity ratio of less than one is 10 per cent. Debt-to-equity ratio is calculated by dividing a company’s total liabilities by its shareholder equity. It is a measure of the degree to which a company is financing its operations through debt versus wholly-owned funds. 

The companies whose share prices have been hit by high leverage include  Bombay Dyeing, TVS Motors, JK Tyres, Vodafone Idea and Piramal Enterprises, among others.

High debt and failure to service debt on time have resulted in huge value erosion for several companies. This has also resulted in credit downgrades, bankruptcy filings and investor aversion.

Analysts said the mood in the markets is to stay away from companies with high debt. On the other hand, companies with no or manageable debt levels have been rewarded by investors. Credit defaults also led to drying up of liquidity, especially for lower-rated companies.

“Generally, too much debt is not good for companies and shareholders because it inhibits a company’s ability to create cash surplus. Furthermore, high debt levels may negatively affect equity shareholders, who are last in line for claiming payback from a company that becomes bankrupt,” said Deepak Jasani, head of retail research, HDFC Securities.

While high debt-to-equity ratio is considered bad, experts advise investors to check whether the debt is meant to repay/refinance old debts, or for new projects that could have the potential to increase revenues.

“This situation is difficult to reverse unless the economic situation improves or entities with deep pockets form strategic partnerships with these companies,” said Jasani. Some analysts said the woes of highly-leveraged firms had been compounded by the sluggish economic growth.

“When there is an economic slowdown, corporate top lines tend to moderate, and margins tend to soften because of operating leverage. This is because fixed costs get apportioned over a lesser number of units produced, which in turn, bring margins down. Interest costs on term borrowings, for example, have to be paid irrespective of whether sales are up or down. Impact on the earnings of highly-leveraged companies during a slowdown is therefore much higher,” said UR Bhat, director, Dalton Capital.

Experts advised investors to stay away from highly-leveraged companies as a turnaround looks unlikely in the near term. “Markets have been expecting a turnaround in earnings growth for the last two years, but earnings have continued to disappoint. Analysts are even pencilling in double-digit growth in FY20. There is no prospect of an immediate earnings revival, and hence valuations are not inexpensive even after the moderate correction. Therefore, there is no great reason for people to rush to invest at this juncture, least of all, in highly-leveraged companies,” said Bhat.

The weak market conditions have further battered the price of highly-leveraged stocks. Markets have been on a rough patch throughout this year due to a string of concerns, including fears of a global slowdown, lack of earnings growth and liquidity issues, among others. 

The Budget brought with it a string of issues which pulled the markets further down, including a surcharge on foreign portfolio investors (FPIs). There was also lack of a stimulus package to revive the economic slowdown and the Centre’s proposal to increase the minimum public float, which hit the markets.