Interest Rates, Debt & Leverage

Photo by PiggyBank on Unsplash

There is often much confusion about how debt, interest rates, and leverage impact listed companies. This post only ties in the seemingly important ideas and observations. This is not a comprehensive and all-encompassing post but I hope this serves as a ballpark idea of how much debt may or may not be good for a company you might have invested in.

Valuation of a firm

The value of an unlevered firm is the total value of the discounted cash flow of its future operations where the (cost of equity) discounting multiple may change depending on the operations and risk of the company. Judgment is often required for the discounting rate and future cashflows.

In the case of a levered firm, the value of the firm (as outlined by the MM Proposition) is the value of the firm without leverage plus the value of its debt after the tax shield the debt would allow.

In simple terms, Value of the firm = Value of its Equity + Value of its Debt

Impact of Interest Rates

  1. Lower interest rates- reduce the discounting rate for future cash flows and increase the equity and debt value.
  2. Higher interest rates- increases the discounting rate for future cash flows and decrease the equity and debt value.

However, this effect is amplified for debt and hence debt is more sensitive to interest rates than equity.

This also ties in correlation with the money supply. In a low-interest rate environment, there is a high money supply and since resources and securities are in limited supply, more money chasing fewer assets drives their prices higher. This effect is reversed when the interest rates go up and this is also why higher interest rates are correlated with cooling off inflation. Because of their impact on debt, during low-interest rates companies with higher debt move up the fastest and vice versa. Usually, high debt companies also get a chance to renegotiate borrowings and a high money supply led higher earnings can also help them reduce debt and make them look like “retrospectively obvious turnaround stories”.

Leverage and Growth

the exertion of force by means of a lever

In the context of companies, the lever is borrowed money, the force is the operations of a company and the output is growing revenues. Any company with high debt would have high ROE and hence a high growth (in theory). For most companies, the leverage (debt) would allow them to invest in more productive assets than what they would’ve been able to with the previously lower amount of equity. Though all of the assets would be responsible for generating the “net income” we would only divide that by the smaller “equity” to get the ROE figure and hence high debt would mostly lead to a high ROE figure. High debt also means high interest which translates to a high tax shield and hence more earnings.

So, is debt good or bad?

Effectively there is no single word answer to that since it always depends on how companies use this. We could find instances to argue each side of the case and stats would pile up and yet no conclusive answer for that question would exist.

However, there are ratios and metrics developed to help you understand if a specific company their leverage situation is healthy or not.

Metrics to judge leverage

  • The Debt-to-Equity (D/E) Ratio: This is expressed as the total borrowings/ total shareholder’s equity. Total shareholder’s equity = reserves + share capital. This ratio tells us how much of the company's assets are financed by debt, while a high ratio may sound bad it may not necessarily be a bad thing if the company has managed to borrow for cheap or use such capital efficiently enough to drive growth.

For instance: companies like M&M and JSW Steel both have maintained a D/E ratio of over 1 for at least the past 8 years and still managed to generate returns for equity investors. Adani Green has generated massive returns though they have a 20x D/E. So there is no necessary relation between D/E and stock returns.

  • Interest Coverage Ratio: This is expressed as EBIT/ Interest Expense. A major glitch with only looking at a company’s debt, liability, or asset position is they tell you nothing about the company’s ability to service its borrowings. This fixes exactly that by telling us the number of times a company can pay their interest expense with only their operating profits. However, we can not say one ratio is better than the other, but it depends on what you might be looking for. Generally, a ratio of 4 or above is considered desirable but that would depend on the industry too.

For instance: HPCL a company with a 1.17x D/E and an above 10x interest coverage has not managed to generate wealth for investors over the past 5 years. Whereas, BLUE DART with 1.22x D/E and 7.30x interest coverage has generated over 70% returns in the same time. Even JK paper with a similar leverage ratio of Blue Dart and growth similar to HPCL has managed to return 2.21x to their investors in the same period.

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Craving Alpha

Craving Alpha

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Leveraging Research and Data Science to create actionable investing strategies in the stock markets. All posts are educational | more on www.cravingalpha.com