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Debt impact

There is a need for debt analysis for undertaking equity investments as this can play an important role in determining the performance of a company. Arnav Pandya tells more.

business Updated: Aug 27, 2007 00:28 IST

Majority of the investors look at the developments in debt markets only for the purpose of evaluating their debt investments. There is a need for debt analysis for undertaking equity investments as this can play an important role in determining the performance of a company and consequently its stock price movement. Most of the investors find it difficult to establish a connection between these two areas. Here are a few points that could be considered.

Rates in debt market
The prevailing rates in the debt market are a very important component to arrive at the total cost of capital for a company. If an event has resulted in a rise in rates, then the impact could be seen on the overall interest cost of the company an investor has invested in. A sharp rise in borrowing costs can impact their margins and thereby affecting overall profitability. That is the reason such developments in general are considered “negative” by equity markets.

How to track it

• Tracking debt markets is important for equity investments too
• High rates can raise the interest expenses which impacts profits
• Amount of debt determines the quantum of impact
• Specific nature
of the debt can curb costs
• Interlink between markets/areas plays an important role

Amount of debt in portfolio
Apart from the prevailing market rates, it is also important to consider the amount of debt in the books of a company. There are several companies, especially in the information technology space, that have little or no debt. Thus, these companies may not feel the heat of a rise in interest rates. On the other hand, companies in some capital-intensive industries like steel are usually saddled with a huge amount of debt and will be impacted harder by a change in the situation.

Nature of debt

There are different kinds of debt and all of them will not impact the company in the same way. If there is a bit of short-term debt that is getting rolled over quickly, then the cost will be lower -- if there is huge liquidity (availability of funds to be deployed) in the short-term money market and vice versa. This is because the rates applicable to debt will come down with every rollover in a falling rate scenario and vice versa.

If there is a large amount of long-term debt, then the situation prevailing at the time of raising the debt is important. Debt raised during low interest periods will benefit the company if the company opts for a fixed rate regime for its loans. That will keep the interest burden lower. Different kinds of instruments coming up in the market are complicating it further. If the debt issued by the company is convertible, for example, then it calls for a different kind of analysis based on its features. <b1>

Impact of areas
Markets across the world are inter-linked and thus one has to be aware of the different trends emerging in other markets too. For example, a step taken to curb certain trends in the foreign exchange market can have an indirect impact on the debt cost of a company given that as this might choke up foreign funds, forcing the company to raise local funds at a higher cost.

The case in point is the recent ban on domestic companies raising funds through the external commercial borrowing (ECB) route. These kinds of developments are common in the financial markets and one has to be aware of the trickle down impact of such developments to precisely ascertain their impact on equities from time to time.

(The writer is a Certified Financial Planner)