Success mantra: Low debt and high sales growth
An increasing number of Indian companies are finding themselves in a debt trap as their entire operating profit now is not sufficient to meet their finance charges. Worst still, a large number of these companies have negative operating profits and a huge interest burden on top of that. In such a scenario, finding a company with zero or minimal debt (mostly working capital) is the biggest challenge, as these companies are considered multi-baggers.
Most zero-debt companies’ trade at a very high price-to-earnings ratio and enjoy very high investors’ confidence and valuation. These companies are considered relatively safe bets as they don't face the burden of servicing debt in bad times. There's a set of investors who actively look out for companies that either have low debt on their books or are actively bringing down their debt. A combination of high sales growth and low debt is an ideal company to invest in. While debt gives a push to sales growth it also comes at risk of muted earnings growth if leverage is high or interest rates trajectory is upwards. Investors prefer companies who can fund their working capital and capex requirements from internal cash generation.
Finding an optimal level of debt is very subjective. It is just like salt in the food. Too high or too low intake of salt spoils the taste. Post-Lehman crisis, investors have become very selective about companies which have a high level of debt. Many midcap companies have taken huge debt to fund aggressive expansion plans and are still struggling to reduce gearing. Zero debt or minimal debt is one of the key drivers of stock price outperformance, but this should not be the only factor while selecting a stock. Other factors like valuation, earnings growth, and management pedigree must be also be considered. Hence, investors should look at various other parameters before putting their money.

Keep a watch on cash-flows
Zero debt is a function of free cash-flow generation and capital intensity of the business. For companies which have negative free cash-flow, and therefore require funds, debt is always preferred over equity as long as it comes at a cheaper cost of 9-12 per cent compared equity. If we look at the stocks which gave multibagger returns, most of them rallied on hopes of strong earnings recovery, stability in demand environment, as well as growth prospects.
Interest Coverage Ratio indicates the extent to which a company’s earnings are available to meet its finance costs. It measures a company’s operating profit, that is earnings before other income, interest, tax, depreciation and amortization relative to the amount of interest charges which the company pays. Debt free companies maintain their earnings well above their interest obligations and are in a good position to endure economic slowdowns and business setbacks. On the contrary, companies which are not generating enough will find it difficult to service their interest obligations and will have nothing left for distribution amongst the shareholders.

Are all debt free companies good bets?
It is a good practice to keep debt levels as low as possible. But, this should not be done at cost of business growth. Companies which are compromising their growth are either complacent or do not have skilful and dynamic top managers. A combination of high sales growth and low debt is ideal. In a falling interest scenario, companies with high debt will get more than proportionately benefited. Hence, the stage of the cycle of the industry, the efficiency of capital allocation, the management quality, and the robustness of cash flows are some other parameters that also need to be considered in addition to the debt-equity ratio.
(The author is founder, Trade Smart Online. The views expressed are personal)