Debt Free Companies in India: Analysis of Debt on Companies Balance Sheet [2022]

[List of Debt-Free Companies] Analysts and investors like stocks of debt free companies. But it does not mean that all companies with debt on their balance sheet are bad. There are companies that use debt to increase their shareholders’ value (ROE). On the contrary, it is also true that not all debt-free companies qualify as good investments.

So, how one can analyze the debt of a company from the perspective of investing in it? This is what we’ll read in this article.

My stock investment philosophy revolves around value investing. For this, I use my Stock Analysis Engine (SAEngine) to estimate the intrinsic value of stocks.

In my early days, I used to think that debt positively effects the comany’s valuations. My assumption was that, as debt increases the company’s liquidity, it should positively effect the intrinsic value. But while I was coding the intrinsic value algorithm, I gained a different understanding.

Before we see other aspects of debt analysis, allow me to show you the impact of debt on intrinsic value (read here).

Topics

List of Top Debt Free Stocks in India 2022 with 52-Week Low Price

(Updated: 20-Aug-2022)

• ICR = Interest Coverage Ratio

Impact of Debt on Intrinsic Value

Let’s see the debt of companies through the lens of intrinsic value. To understand this, we must first know two basics about debt:

• Types of debt: There are two types of debts visible on companies’ balance sheets, (a) Short term debt (under current liability), & (b) Long term debt (under non-current liability).
• Why company avail debt: Companies generally resort to short-term debt to manage immediate cash flow needs. Short-term debts make the working capital (WC) more liquid. Long-term debts are availed more for the purpose of the company’s expansion plans (CAPEX). Know more about if the debt is good or bad for companies.

Both the above type of debt affects the company’s intrinsic value in their own way. Let’s know more about it.

Impact of Debt On FCF Formula

The debts that will be settled within the next 12 months from the date of borrowing are short-term (ST) debts. And debts with longer repayment time, greater than 12 months, are long-term (LT) debts.

The impact of both ST & LT debts can be understood more clearly using the FCF formula. Intrinsic value is derived from free cash flow to equity (FCFE). Higher will be the free cash flow to equity (FCFE), and more will be the intrinsic value. The formula to calculate FCFE is this:

[P.Note: In the FCFF formula, net new debt is one of the components. But again, while calculating the intrinsic value from FCFFs, the total debt load of the company is first deducted. So in a way, we can say that the influence of debt on intrinsic value is not major. Read more: Difference between FCFF and FCFE]

How does debt affect this FCFE equation? It will have two effects

• First: The interest bearing on the debt will reduce the net profit (PAT). Reduced PAT will result in lower FCFE, hence lower intrinsic value.
• Second: Due to debt, the current liability (CL) will increase. An increase in CL will reduce the Working Capital. As a result, the change in non-cash working capital will be negative. It will result in higher FCFE, hence higher intrinsic value.

So, the net effect on FCFE due to new debt is negligible. A decrease in PAT is offset by the negative change in NCWC. As a result, we can say that the intrinsic value, which is derived from FCFE, remains mostly unaffected by new debt. Read more about the intrinsic value formula here.

Debt-Free Small Cap Stocks

Here is a short list of 10 number debt free small-cap Indian stocks

(Updated: 20-Aug-2022)

List of more small-cap debt-free companies

How to Find Quality Debt-Free Companies

While I was coding an algorithm for debt-free companies for my Stock Analysis Engine (SAEngine), it was clear that I’ll include only FCF-positive companies. A debt-free company will be of no value if it is not yielding a positive free cash flow.

People who are not conversant with FCF or intrinsic value estimation can use my “SAEngine” to find quality Indian zero debt companies. It has a prebuilt stock screener that filters fundamentally strong debt free companies.

Allow me to give you an introduction to the parameters used to filter the debt-free stocks:

We take a small hypothetical example of two companies and do an example debt analysis. Suppose there are two companies ABC & XYZ. Just note how the debt of these two companies is compared using the parameters listed below:

Stage #1 Screening

1. Free Cash Flow (FCF): No company will pass through the filter if its FCF is not positive. This is the first limitation. What’s the logic? There is no point in investing in a company if its FCF, also called the owner’s income, is negative.
2. Absolute Debt: ABC has a debt of Rs.80 Crore and B has a debt of Rs.120 Crore. Which company looks better here? If we have to look only at debt, Company ABC looks less risky, right? My algorithm uses the debt to market cap ratio to make the absolute debt more comparable with other companies. The lower the D/Mcap ratio the better.
3. Debt Minus Cash: Suppose Company ABC and XYZ have cash/cash equivalent reserves of Rs.75 Crore and Rs.132 Crore respectively. Debt minus Cash for Company ABC is Rs.5 Crore (80-75). Debt minus Cash for Company XYZ is Rs.-12 Crore (120-132). A negative value for Company XYZ indicates that the company has enough cash to pay off all its debt. Such companies, even if they carry debt, can behave like zero-debt companies. Suggested Reading: Difference between enterprise value and market cap.

Stage #2 Screening

1. Debt Equity Ratio (D/E): Now suppose, Net worth of ABC is Rs.80 Crore and the Net worth of XYZ is Rs.120 Crore. This means, that the debt-equity ratio (D/E) of ABC is 1 (80/80) and that of XYZ is also 1 (120/120). So which company is better? The Thumb rule is that the lower the debt-to-equity ratio the better. Zero DE companies are called zero debt stocks. Read more: Debt to equity ratio interpretation.
2. Interest Coverage Ratio (ICR): It is a ratio between EBIT and Interest. The higher the ICR ratio the better. Generally speaking, ICR above three is considered safe. Companies having double-digit or higher ICR can behave like zero debt companies.
3. Return on Equity (ROE): Good companies take debt to improve their shareholders’ returns. High ROE, with debt, is an indicator that the company is using its debt well. Read more about ROE calculation.
4. Return on Capital Employed (ROCE): Too much debt can hamper the company’s D/E, ICR, and also its ROCE. ROCE is a measure of the company’s profitability. A company with debt but displaying a higher ROCE can be treated as a zero debt company. Read more about the ROCE formula.

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