Equity shareholders may not be willing to provide 100% funding for such projects as this will bloat the equity and reduce returns.P Saravanan & Aghila Sasidharan
Generally, companies manage their funding requirements through equity or debt or internally generated cash. Empirical evidence states that the most preferred source of funding is internally generated cash, followed by debt and the least preferred source is equity. The reason is clearly based on the associated costs. However, often many companies proudly claim that they are debt-free companies which means that either they have zero debt or insignificant amount of debt. Let us discuss whether debt-free companies are good candidates for investment.
Advantages of debt-free firms
By having less debt or zero debt, companies send a signal to the outside word that they are able to manage their funding requirements predominantly through internally generated cash and thus they are cash-rich firms. During economic slowdown, many a debt-heavy firm’s profits dip owing to falling sales and payment of fixed interest while companies with no debt or less debt need not worry about the same. Thus, they have low interest rate risk. By having less debt in the balance sheet firms are also sending a message to the outside word that they are conservative in nature.
Drawback of being debt-free firms
By not having optimal or adequate amount of debt, these companies lose out to a greater extent on ‘tax shield’. The concept of tax shield is nothing but the treatment of the interest paid by a company as an admissible expense, thus reducing its tax outflow to some extent. Further, debt-free companies could be perceived by the investors as not proactive in nature.
Nature of industry and operational risk
In capital-intensive industries such as iron and steel, cement, telecommunication, etc. not taking debt is extremely difficult. Equity shareholders may not be willing to provide 100% funding for such projects as this will bloat the equity and reduce returns. As these industries have fixed and tangible assets, it is easier for them to raise debt. Generally, for the heavy debt companies, operational risk is less as their revenue continuity and visible profits help them deliver higher return to the equity shareholders.
For instance, look at the large IT firms who have zero debt and no interest rate risks. However, they have different kind of risks such as exchange rate fluctuations, economic and employment conditions in the US, Europe and other major export markets. So, the nature of the industry and associated risk play a major role.
Valuation and business potential
Debt is perhaps a small component in the valuation process of a company and it is largely based on the expected free cash flow which is the outcome of the business potential. It could be wrong to paint debt-free and debt-heavy companies with the same brush without looking at the specific nature of the business and associated risks.
To conclude, an investor should not only look at whether a company is debt-free or debt-heavy but also many other relevant factors such as nature of the industry, business model and its potential to survive in the long run, financial history, earnings multiple and the like.
P Saravanan is a professor of finance and accounting, IIM Tiruchirappalli while S Aghila is a doctoral research scholar from IIT Madras, currently doing her internship in IIM Tiruchirappalli