Is investing in debt-free companies a good idea?

investing in debt free companies

Companies in India that had no or little debt have managed to stay clear of the hit India had faced within the last few years over its economics. Some of the reasons for the hit were the spike in interest rates and the others are the rise in input costs. Therefore there has been a huge shadow over the companies in India that borrowed significant capital. 

 

Companies manage their funding requirements through equity or debt or internal cash generation. The most preferred source of funding is through internal cash accrual followed by debt and the least is equity. Therefore, companies do take pride in claiming that they are debt-free companies which means that they have zero debt or it is an almost negligible amount. 

 

When interest rates are on the rise, the companies with debt face a huge impact as the company’s cost of borrowing funds increases due to this. Due to this, the servicing debt of that company becomes increasingly expensive and starts utilizing the company’s profit. 

 

While most leveraged companies face a strain on cash flows, debt-free companies in India

are free of these hassles in particular. Debt-free company stocks are in a much better position in these situations. But does this mean that investing in debt-free companies in India is a good idea? In this article, we are further going to discuss the pros and cons of investing in a debt-free company. 

The impact of debt on companies

A low-interest rate outgo will allow a company to retain more cash. It can be used for more investment in the business or as a dividend to its shareholders depending on what is best for its prospects. 

 

A hike in interest rates directly leads to an increase in a company’s debt. This debt means that the company’s profits are directly reduced as compared to those companies that have little to no debt. A lower equity debt-equity ratio is often an indication of a firm’s resilience in poor economic conditions.

 

Debt-free companies in India find it easier to avail of funds at a lower rate since they are often considered less risky in terms of their ability to service a loan. Not only this, but they can raise equity capital more easily than a company with more debt. 

 

Considering the data across 5 years, the stocks with less than Rs 500 crore debt have delivered 186% return on average, whereas those with more than Rs 500 crore debt have yielded a mere 12%. 

Top 10 debt free companies in India

Debt free company list

Sector

TCS

Information Technology 

Infosys

Information Technology 

Mindtree

Information Technology 

Divi’s laboratories

Pharmaceutical 

Gland Pharma

Pharmaceutical

Larsen & Toubro Infotech

Technology consulting and digital solutions

Hindustan Unilever

FMCG

IRCTC

Railways

Bharat Electronics

Aerospace and defence electronics

SBI Life Insurance

Life Insurance

Is low debt always a good option to invest in? 

Not really. Many factors make a company a good investment. Debt is just one of them.

 

In some cases, a low debt might also look like a red flag. For example, if a company has low debt in strong economic times where growth is expected then why is the company choosing to ignore the visibility of clear growth? 

 

By not having an optimal amount of debt, companies lose out to a greater extent on tax shields which is the process of the interest paid by a company for an admissible expense. It helps in the reduction of its tax outlaw to some extent. 

 

By saving on the interest charges, a company might also be sacrificing growth on its own. All debt-heavy companies may necessarily not be a  bad investment if they have a high growth model. 

 

Hence, low leverage can put a company in question in strong economic times putting a question on the further development of the company. 

 

Here are some of the pros and cons of investing in debt free companies to help you understand it better.

 

PROS

CONS

Can avail funds easily

Higher cost of financing

Less risk of bankruptcy

Lower EPS ratio  (earning per share) due to Financing via equity

Higher profit margin is booked

Financing via equity leads to paying more taxes as compared to financing via debt

Strong financials 

 

Valuation of Companies

Debt is a small component present in the valuation process of any company. It is based on the expected free cash flow. Debt-free and debt-heavy companies cannot be seen through the same perspective, therefore an investor needs to look at the specific structure of the business and its related risks.

 

An investor should not invest in a stock depending only on one factor of the company. An in-depth research of the company is more important which can include factors such as the nature of the industry, business model and its potential to survive in the long run, financial history, earnings multiple, etc for an investor to look at.

Conclusion

Sticking to low debt is a good choice in the current environment. Debt-free companies are offering a safer investment. Investors have been and will continue to prefer businesses with low or no debt. 

 

The economic situation going around is still not in a good shape right now. Therefore even if the economic recovery comes into the picture in a few years, the cash-positive companies will still be in a strong position in the market. 

 

To sum up, an investor can look at the situation of debt as a strong factor considering other aspects also i.e. nature of the industry, business model, financial history, and earning multiples etc. while making a decision.

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