Zero Debt Companies are Financially Stable: A Myopic View | Dhameja, Dhameja & Khatter

Two main sources of funds which companies normally tap include equity and debt; in addition, for existing companies their internal funds are preferred sources. Every source has a cost, internal funds though don’t have explicit cost, shareholders expect return as that of equity, and debt has relatively low cost due to the tax exemption. Debt can be in the form of borrowings or through issue of bonds or debentures, borrowings are relatively procedurally simple and less costly.

Debt adds to company’s liability, is shown in the balance sheet, and has to be serviced by paying interest and periodical repayment as per agreed terms. As such, debt comes at a cost, explicit cost in terms of specified interest plus implicit cost in term of covenants attached. Interest payment reduces profits, in the worst-case scenario, high debt can push the company into bankruptcy due to its inability to meet timely repayments; whereas debt-free companies typically meet their funding needs through their reserves or cash flows, and have better control over their finances.

Companies having no outstanding debt, or are debt free, as shown in their balance sheets, are considered financially stable, and take financial decisions based on business needs rather than constrained by debt obligations. These companies apparently have more financial flexibility, and interest payment and interest rate fluctuation has limited impact on stock prices. Thus, debt free companies represent a beacon of financial prudence and stability in an otherwise volatile economic environment.

Debt though has a cost, interest is to be paid and affects cash flows, this is particularly so when interest rates are increasing. As such during period of rising interest rates, debt free companies, will be free from the rising interest rates. In fact, with rising interest rates all over the world, finance risk has increased as high interest expenses eat into the profits of companies; and many investors look for debt-free stocks while investing in stocks.

Debt free companies having zero interest included the following – both public sector (market asterisk) or private companies.

Bajaj Autos
Jio Financials
TCS
Infosys
ITC
HUL
Maruti Suzuki India
United Breweries
Finolex Cables
HAL
BEL
Bharat Dynamics

It may be mentioned that among NSE companies, more than 500 companies have zero debt.

As we know, interest is a charge on profits, and is allowed as a deduction from profit for tax purposes, with tax shield, debt comes at a lower cost. For example, for a company in a tax bracket of 30 percent and 15 percent debt, the effective cost of debt would be 10.5 percent i.e. 15% (1-t). So, all debt is not bad, it reduces tax liability and for companies having good growth potentials, debt is an economical source. Conceptually, companies having zero debt or small amount of debt having nil or low interest obligation due to tax shield, would have relatively lower return on equity due to loss of opportunity of tax shield benefit.

As illustrated in Appendix I, Company B with Debt: Equity ratio of 2 :1, has higher return on equity (ROE) of 62 percent, while company A in the same industry with zero debt, will have return on equity (ROE) of 28 percent, (assuming turnover to capital employed as one; profit margin as 40 percent, and corporate tax of 30 percent). Similarly at profit margin of 20 percent, the respective ROE works out to be 20.4 percent for company B, and 14 percent for company A.

Further, in case for very low profit margin of 12 percent, company B having debt would have relatively poor return on equity (ROE) i.e. 4.2 percent; while company A with zero debt ROE would be 8.4 percent. (Appendix 1).
Thus, leveraged company enjoys higher return on equity, and only in situation of low margin, leveraged company shows poor financial results. Further, as shown in Appendix II, debt as a source of finance accounts for less than 10 percent of product cost; and even in adversely affected economic scenario, two-fold increase in finance cost would not have that much impact on ROE, though stock prices may be affected due to signalling factor. In that situation, to say that zero debt or low debt company is financially stable as rising financial cost is normally cyclical or a short period phenomena. Every business has some risk- may be business risk and financial risk; avoiding financial risk by having zero debt or small debt, would result in losing of an opportunity of drawing benefit of tax shield. As such, high growth profitable company having zero or small debt can be viewed that the management is having a conservative policy of capital structure.

In that respect, it would be. appropriate to state that companies while deciding about their capital structure, reduce their debt or become debt free considering many factors. For example, infrastructure major Larsen & Toubro had been working to be debt free since 2019 after the markets regulator, SEBI stalled its ₹9,000 crore share-buy-back plan quoting that its debt would swell if it goes ahead with the buyback. For that purpose, the company made payment of its debt from the sale proceeds of its short-term investments and treasury income and dividend income from its subsidiaries.
Similarly, Vedanta Group whose business spans from Zinc to silver, iron ore to aluminium, and Oil and Gas, had borrowings, and its founder and chairman Anil Agarwal said,” we have enough cash flows to service the debt” We have never defaulted to any payment and we always have a plan to make the payments and it is “absolute irrelevant” to talk about the debt repayment capability of the group. This doubt perhaps originated from the scrutiny of Indian conglomerates Gautam Adani Group following a US Hindenburg short selling attack on the Group.

Vedanta Group had billions of dollars of investment and that the debt was the result of huge investment across businesses, and the group had sufficient cash flows to repay the outstanding debt; the chairman said that the group would be a net zero deb company in 2 – 3 years’ time. The chairman also said that the conglomerate had plans to build capacities in zinc, oil and gas and aluminium businesses; it had already invested US $ 35 billion in the country so far, had further plans to become US $100 company by 2030, and so might take debt in pursuit of its aggressive expansion plans.

Tata Steel is another example to show that debt is beneficial in case of expansion and growth potential. Tata Steel’s gross debt end of fiscal 2021 – 22 stood at Rs 75,561 crore after repayment of debt of Rs 15,232 crore during the year. The Chairman N. Chandrasekaran announced at the 115th Annual General Meeting on June 28th, 2022 that the company would reduce its debt by around $ 1 billion (RS. 7896 crore) a year but the company, given its expansion plan, had no plan to reduce its net debt to zero level.

Further, Tata Steel had planned to spend Rs 10,000 crore-Rs 12,000 crore a year on capital expenditure and that could even increase further. To quote the chairman, “The main thing is to have the right capital structure, and not blindly go for zero debt. Currently our debt-to-equity ratio and the debt to EBITDA ratio are both less than one. The company has a capital structure which is very strong and taking to zero debt can make the company’s capital structure inefficient.” 

With the ongoing expansion plans at the Kalinganagar and Angul plants, that would take the capacity to 25 million tonnes and the company planned to increase its capacity to 30-40 million tonnes.

To conclude, debt is an importance source, it has low cost, a committed cost, it reduces cashflows after deducting it from profit; it has the benefit of tax shield.

Debt-free companies because of absence of committed cost, have relatively low risk and are preferred by investors. However, considering only a company’s debt position while investing or looking at the profitability would be myopic. Besides the total debt and debt-to-equity ratio, one should consider other parameters to filter stocks. Moreover, one should check the fundamental and technical aspects of the debt-free company while deciding about his investment plan. One should choose profitable companies that could yield a good return. Just being debt-free should not be the primary deciding factor. Debt is a sugar quoted pill, beneficial if taken within limit in proper perspective.

For that purpose, ‘Star’ companies as per Boston Consulting Matrix, having high growth potential would yield high return with high leverage and tax shield benefits otherwise it would be situation of lost opportunity.

Moreover, it is a common phenomenon that Indian credit card users spend 40 X more than those of debt card users online. Similarly, lower interest rates and increasing housing property prices during great depression in early nineties, investors found it attractive to invest in house properties; they borrowed more than they needed and at the peak of the boom, many of the households had Rs. 40 of borrowings for every rupee of capital; and defaulted on repayment when due. It emphasises the importance of having an appropriate and right rate of interest. In the words of, Acharya Chanakya, “debt is like an enemy”; debt makes a person feel small in front of others and also pulls him away from celebrating anything in his life because he is constantly irked by that debt. As such, excess borrowings are a step towards dooms-day for companies especially those experiencing financial distress and adversely affect the solvency and sustainability of the enterprise, or of the economy. At micro level, financial institutions and regulatory bodies normally lay down norms for debt-equity ratio; normal debt-equity ratio is 2:1, while for infrastructure projects the norm is 4 : 1.

Similarly, at macro level, countries use debt for their development but with certain limit. Only a few small countries including, Liechtenstein, Macau, Palau, Nauru do not use debt, they focus on development through investing in key industries such as tourism, manufacturing, oil production. Normally, governments have laid down some norms for debt. For example, countries such as, Poland, Keny, Malaysia, Namibia and Pakistan have debt ceiling as percentage of gross domestic product. Similarly, European Union pledge to keep the public debt below 60 percent of GDP and the annual deficit below three percent. However, several EU countries have exceeded the limits and a revision of the rules is planned; India has debt as a percent of GDP of approximately 65 percent. As against the debt norm in relation to GDP, USA and Denmark are two countries having limit on debt in absolute amounts; and the Senate USA passed the “Debt Ceiling Act” in early 2023, extending the national debt ceiling until January 1, 2025, avoiding the financial crisis caused by debt default.

Annexure I

Appendix II
Financial Cost as Percentage of Total Expenses

(Authors: Dr. Nand L. Dhameja Professor Emeritus, MRIIS, Faridabad;
Manish Dhameja, Senior Banker having experience in South Asia, Africa and Middle East; Dr. Ridhi Khatter, Associate Professor, MRIIS, Faridabad)

Note: Views expressed are of the authors and not the organisations to which they belong