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Debt Trap-How It Can Drown Businesses And Investors

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Time and again, the stock market offers many valuable opportunities and lessons to investors. It is perfectly okay for investors to miss some of those opportunities, but it is crucial not to miss out on the lessons.

One of the most important lessons which every investor should know is the perils of investing in debt-laden companies and why it makes sense to steer clear from such companies.

Why companies go for debt?

Businesses need capital for expanding or diversifying their business. In case the company’s earnings are not generating a surplus, the next option is opting for loans. However going overboard with debt can be disastrous, at times for businesses as it puts too much pressure on them, especially when there is economic distress.

Videocon, a classic example of how massive debt can destroy a business and shareholder wealth

I am sure you might have heard of Videocon, which ruled the Indian consumer electronics market long before Samsung, LG and Sony entered the scene. Videocon was a household name across India until a few years back with a vast product line-up which included washing machines, refrigerators, air conditioners, televisions and home entertainment systems.

Everything was fine as long as the company was dabbling in consumer electronics in the ’90s. However, in the 2000s, the company went on a rapid expansion mode by entering into new verticles of business such as DTH, energy and telecom. And for this, it took massive debts.

On one side while the company’s debt started piling up, on the other hand, the company’s capacity to pay off the debt started weakening as the new businesses were highly capital intensive and were not making enough revenues. Despite Videocon’s diversification to multiple businesses, consumer electronics was still the biggest revenue generator. However, Videocon’s consumer business too suffered a considerable setback with intense competition from international brands.

With falling revenues and rising interest costs, Videocon was unable to service its debt. Selling off its DTH and oil and gas business did not help much. As a result, the company ended up with more debt than value.

Massive debt for expansion turned Videocon Industries from a profit-making company to a bankrupt company which is currently undergoing insolvency proceedings under the National Company Law Tribunal (NCLT).

An investment of Rs. 1,00,000 in shares of Videocon Industries on 1st Jan 2008 would be worth just Rs. 176 today. Can you imagine the extent of investor wealth the stock has eroded?

Don’t invest in debt-laden companies: A timeless lesson at Dalal street

Unitech, JP Associates, Reliance Power and Suzlon are some of the best examples of debt-laden companies which have destroyed investor wealth by huge margins. It is a well-known fact that debt-laden companies take the biggest hit during a phase of an economic slowdown.

In an economic downturn when earnings of businesses fall, the interest payments on debt don’t stop. As a result, there could be a default of payments, piling up of additional interest. As a last resort, businesses may even have to resort to selling assets. On the other hand, cash-rich companies have enough funds to withstand the recession, which at the most, may last for a few months or a year or two.

Investors often make the crucial mistake of selecting their investments based on market capitalization. However, market capitalization does not denote the actual value of a company as it does not include vital factors like the company’s debt and its cash reserves.

To give you an example of why investing based on market capitalization is a bad idea, let’s take a look at the case of Tata Motors and Maruti Suzuki, which are market leaders in their respective segments in the auto industry.

Tata Motors has a market capitalization of Rs. 49,258.17 crores whereas Maruti Suzuki has a market capitalization of Rs. 216,159.43 crores. At Rs. 170.20, the stock of Tata Motors looks quite cheap compared to the share of Maruti Suzuki which trades at a high price of Rs. 7130.90.

But does this make the stock of Tata Motors a better buy among the two?

The answer is no. Because the total debt of Tata Motors stood at Rs. 28,826 crores as on Mar 2019, as compared to Rs.149.60 crores of Maruti Suzuki during the same period. So despite trading at a higher price, the stock of Maruti Suzuki offers better value to investors.

To conclude, not all companies with high debt may turn out to be bad investments. However, as an investor, you need to invest only in those companies which have a debt to equity ratio of zero or less than one. For some companies, loans may be necessary to expand and grow. Still, from an investor’s perspective, it is essential to undertake thorough due diligence to avoid debt traps like Suzlon or Videocon Industries.

Click here to know more about investing in fundamentally sound companies which can multiply your wealth creation by 4-5 times in 5 years.

Read more:  How Long-term investing helps create life-changing wealth – TOI.

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