Tuesday, November 10, 2009

Why rising debt pose a threat?

Many companies face a dilemma when ROCE decline due to increasing competition in a business. On one hand they can continue with their current business and wait for better times and on the other hand they can increase the debt to expand a business so that when better times arrive the company can take better advantage of it. But the second option has a lot of risk and there are many examples observed in the Indian Capital Market.

One example is the pharmaceutical company, Wockhardt. Following table shows how the company kept increasing its debt during the past few years:

YearROCEDebtDebt (consolidated)

The company's consolidated revenues in 2006, 2007 and 2008 were below its consolidated debt. The consolidated ROCE would look much worse than the figures above and will surely be in single digits. The company's interest cost on consolidated basis increased from INR 97 million in CY05 to INR 2712.5 million in CY08. The company incurred hedging losses to the tune of INR 5800 million in CY08 and had already incurred hedging losses of INR 4320 million in the first three quarters of CY09.

The company's share price hit a lifetime high of INR 562 in March 2006 and a low of INR 67.5 in March 2009, a decline of 88% in three years. Today its trading around INR 190, 66% below its all time high even after three years.

When investing in a company, make sure the management is not so ambitious that they try to achieve their ambition at a cost of their shareholders' wealth.
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