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HomeFinancial ValuationDebt vs. Return: Unpacking the relationship with real-world data

Debt vs. Return: Unpacking the relationship with real-world data

Debt can be a powerful tool for companies, enabling them to expand operations, invest in new ventures, and acquire assets. When used strategically, debt can fuel significant growth, translating into higher returns for shareholders. However, excessive debt can become a burden, increasing fixed costs, reducing financial flexibility, and exposing the company to financial distress during economic downturns. Analyzing real-world data, we uncover the potential risks associated with high debt levels for companies and investors alike.

Debt and Returns Under the Microscope

Our analysis reveals two distinct groups of companies:

Group 1: Low Debt, Positive Returns

This group comprises 22 companies with a debt-to-equity ratio below 1 and positive returns. The average return for this group stands at 4.64%, showcasing a healthy performance. Companies like CRISIL Ltd., Coromandel International Ltd., and L&T Technology Services Ltd. exemplify this group, boasting zero debt and positive returns (See Table 1).

Sr. No Company Name Weekly Returns (%) Total Debt/Equity
1 Reliance Communications Ltd. 18.92 -0.63
2 Max Financial Services Ltd. 10.33 0.15
3 Alkem Laboratories Ltd. 7.64 0.14
4 Canara Bank 7.36 0.82
5 CRISIL Ltd. 6.66 0
6 Apollo Hospitals Enterprise Ltd. 6.3 0.44
7 GMR Airports Infrastructure Ltd. 5.46 0
8 Torrent Power Ltd. 5.17 0.95
9 Oil India Ltd. 5.14 0.48
10 The Indian Hotels Company Ltd. 4.72 0.1
11 Ipca Laboratories Ltd. 4.68 0.25
12 Voltas Ltd. 3.94 0.12
13 Info Edge (India) Ltd. 3.18 0
14 Mphasis Ltd. 2.67 0.03
15 Oberoi Realty Ltd. 2.57 0.32
16 Coromandel International Ltd. 2.25 0
17 L&T Technology Services Ltd. 1.67 0
18 PI Industries Ltd. 1.4 0
19 Dr. Lal Pathlabs Ltd. 0.97 0.15
20 Gujarat State Petronet Ltd. 0.7 0
21 SRF Ltd. 0.2 0.42
22 Syngene International Ltd. 0.2 0.16
  Average 4.64 0.18

Group 2: High Debt, Negative Returns

This group consists of 11 companies with a debt-to-equity ratio exceeding 1 and experiencing negative returns. The average return for this group is a concerning -8.32%, significantly higher than the positive return group. Companies like Future Retail Ltd., Housing & Urban Development Corporation Ltd., and Suzlon Energy Ltd. fall into this category, highlighting the potential downside of excessive debt (See Table 2).

Sr. No Company Name Weekly Returns (%) Total Debt/Equity
1 Future Retail Ltd. -9.52 10.52
2 Housing & Urban Development Corporation Ltd. -13.39 4.07
3 TVS Motor Company Ltd. -0.05 3.93
4 Godrej Industries Ltd. -6.68 2.44
5 Reliance Power Ltd. -9.55 1.84
6 Suzlon Energy Ltd. -9.67 1.73
7 Mangalore Refinery and Petrochemicals Ltd. -4.65 1.69
8 Varroc Engineering Ltd. -14.22 1.67
9 IRB Infrastructure Developers Ltd. -9.21 1.18
10 Biocon Ltd. -2.73 1.01
11 Bharat Forge Ltd. -11.82 1.01
  Average -8.32 2.83

 

A Balancing Act

Analysing the provided data on a pool of 90 companies reveals a complex relationship between debt-to-equity (D/E) ratio and returns. While the initial observation suggests both high and low-debt companies experienced more negative returns than positive, a deeper analysis reveals several key insights.

High Debt Magnifies Risk

Companies with a D/E ratio greater than 1 exhibited significantly higher negative returns compared to positive ones. This indicates that high debt acts as a double-edged sword, amplifying both gains and losses. While it can potentially lead to higher returns during economic booms, it also significantly magnifies losses during downturns or unexpected events due to fixed interest expenses and reduced financial flexibility.

Read: Impact of Debt Reduction On Stock Returns

Low Debt Doesn’t Guarantee Success

Interestingly, companies with a D/E ratio below 1 also witnessed more negative returns than positive ones. This highlights that debt is not the sole factor influencing returns. Other factors, such as industry downturns, poor management decisions, or company-specific issues, can also contribute to negative performance, even for companies with moderate or no debt.

The Importance of Balance

The data emphasizes the need for strategic debt management. While debt can be a valuable tool for growth, using it excessively increases the risk of negative returns. Conversely, avoiding debt altogether might limit growth opportunities. Therefore, finding the optimal balance between debt and equity is crucial for companies to achieve sustainable growth and mitigate risk.

Conclusion

In conclusion, while the data suggests a link between D/E ratio and returns, it’s crucial to remember that the relationship is nuanced and influenced by various factors. Investors and companies alike should carefully navigate the debt labyrinth, balancing growth aspirations with risk management to achieve long-term success.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions. 
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