Companies carry out daily businesses with capital. This capital is either their own fund or they borrow the capital from somewhere. Different companies have different kinds of financial condition. A company either uses its own capital or it may borrow the fund from a bank or any other financial institutions to run the business. Here we will discuss the benefits of investment in debt free companies.
What is Debt: Equity ratio
Debt: Equity ratio is the comparison between a company’s own capital and the debt which the company borrows from a bank or a financial institution. Suppose a company has a capital of Rs. 100/- and it has borrowed Rs. 100 from a bank. So the debt ratio of the company is 100:100 = 1
When a company borrows fund from somewhere, obviously it is subject to pay off the debt to the lender. The company pays off the debt including interest from the profit the company earns by carrying out its business. Generally it is noticed that a highly debt company has to spend a lion share of its profit to repay the debt. After the payment of debt, the company is left with a little amount of the profit margin from operations. The small amount of money is not enough to expand a business i.e., setting up a new factory throughout the country or restructuring the company.
On the other hand, a debt free company or a company with marginal debt does not have to face the burden of any kind of repayment of loan. So, it can use its profit margin for the enlargement of its business leading to higher profit margin in the near future. As a result, the shareholders will get better capital appreciation and good dividend payout.
Why you should not invest in companies which has high Debt: Equity ratio
The main concern of highly debt companies is that any kind of hike in interest rate by banks or financial institutions increases the expense ratio for the highly debt companies. Then naturally, this additional expense affects the net profit margin and dividend payment of its shareholders. Let us illustrate what the difference is between a highly debt company and debt-free company. When a company has a huge debt from the market or bank or commercial institution, then the company concentrates on the debt and its effort goes to repay the debt. The respective company cannot be sincere about the service, quality of the product or any other important aspects needed for the business. If the company is debt free the company can concentrate on product quality, service and customer satisfaction only. That is why a debt-free company is better than a high debt company. From the above discussion it is concluded that at the time of investment in any stock one common individual must be aware of the stocks’ Debt ratio.
The benefits of investment in debt free companies
The benefits of investment in debt free companies are as follows:
The Debt free companies are capable to deliver better returns just because they are self-reliant. Debt is a temporary solution for the financial crisis. Debt costs larger in the long run. Your task is to choose a company or stock which is debt free. A debt free company allots good dividend yield, better return on equity to its share holders. As a retail investor of that respective stock, you will receive a good dividend yield or dividend payout from that company or stock you have invested in. So, smart work is to analyse a stock’s debt ratio first before investing.
Banks also prefer those companies which have low debt ratio or which repay the loan within the scheduled time. In addition to banks charge lower interest rate to those companies which have low debt in comparison to highly debt companies or stocks. Bankers also fear that these highly debt companies may increase the bank’s NPA.
You need to keep a close eye on what the management policy or road-map a company maintains to pay off the debt in the future. With an appropriate road-map, a company can clear out the debt it receives for business. Then after the complete repayment of loan, the company can now use its profit for restructuring and expansion of the company i.e., setting up production units all around the country. With this business expansion, the sales and the profit margin increase over the long term. So, when the profit margin increases the company will deliver good numbers and have good dividend yield to its shareholders.
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