Whenever a large business group expands quickly, thoughtful investors ask how that growth is being financed and governed. Participants in the market who follow Adani Shares frequently debate leverage, board independence and transparency, and those debates offer lessons for any large Indian company. Likewise, analysts examining the Adani Power Share Price keep an eye on borrowing levels because capital-heavy generation businesses depend on long-term loans. Instead of relying on opinions, you can build a simple checklist that tests any company against the same standards. The sections below describe such a checklist in plain language.
Step One: Examine the Debt Structure
Start with the quantum of borrowing and classify it into short- and long-term. Short-term borrowings that need to be renewed in the near future are a worry if the credit markets tighten. Debts that fund long-term assets, however, are not a cause for concern.
The second test is the interest coverage ratio or the ratio of operating profits to the interest payable. A ratio of more than two or three times is good. From a risk perspective, one does not want a ratio that is closer to one. Look out for the quantum of borrowings that are at a fixed rate of interest and the risk that rate hikes could cause. The rating of the company by domestic credit rating agencies is a good indicator of the company’s default risk, provided you go beyond the rating and look at its rationale.
Step 2: Test the quality of cash flow
Net profit is not the same as cash flow. Compare the net profit with the cash flow from operations for a few years to see if cash flow is consistently lower, which could be an indication of the company trying to cook the books. Look at capital expenditure (CapEx) as a percentage of accruals. Firms that finance a major portion of their CapEx from accruals are better than those that have to depend on new borrowings to fund their growth.
Free cash flow (FCF) has to be looked at closely. If a firm has negative FCF or one that is barely positive, it means that the firm is not able to fund its capital expenses from operations and has to resort to external financing. In this scenario, one has to look at whether the firm’s expenses will result in returns in the future.
Step 3: Review the board composition and related party transactions
Governance is about who is accountable for what. Look at the composition of the board, independent directors and their tenure, and special committees such as audit and risk management committees. Do the firms have honest and independent professionals heading the audit and risk management committees? Are there frequent changes in auditors or independent directors?
Related party transactions are a delicate issue. Although there is nothing wrong with transactions per se, such transactions should be on an arm’s-length basis and be approved by independent directors. Transactions within a group that involve sale/purchase of goods and services or loans and guarantees need to be scrutinized. The quantum of such transactions as a percentage of revenue or assets gives a good idea of the extent of related party dealings.
Step 4: Read between the lines in disclosures
A company’s disclosures in the auditor’s report, contingent liabilities and the management’s discussion of risks are important. There are always contingencies that need to be guarded against, such as disputed taxes or guarantees given to third parties, which could turn out to be liabilities.
The shareholding pattern in different quarters reveals whether institutional investors or promoters are buying or selling in the stock. Promoters and domestic mutual funds are good buyers; a consistent selling by the latter could be a bad omen. Look out for regulatory and judicial updates from official websites and do not get carried away by rumors.
Step 5: Gauge your risk appetite
The final step is to look at the risk in terms of your requirements and profile. A strong set of fundamentals does not mean there are no risks. Similarly, a weak company does not always mean the stock is bound to fall. The fundamentals merely add another layer of security for someone with a long-term investment horizon and a diversified portfolio. A person nearing retirement may want to avoid too much risk. The best way to look at fundamentals is to take a call on the risk-reward equation based on the above five steps and then decide on the allocation to a particular company or sector.
Remember, you should not hold too large a portion of your portfolio in one company or group. You could go through this risk meter every quarter and revise your decisions on a stock based on new information.
