MENU

An Example Of Poor Financing Decisions

Pay 

Recently, real estate company CapitaLand  (SGX: C31) made some smart financing moves by replacing some of its loans with relatively cheaper (in terms of interest payments) ones. That’s beneficial for shareholders as that would mean lesser interest-related expenses would have to be paid by the company in the future.

Unfortunately, not every company’s financing actions can be said to be beneficial for its shareholders. Chinese fashion apparel manufacturer and distributor Eratat Lifestyle Limited (SGX: FO8) is perhaps one such negative example.

On 20 June 2013, the company made an announcement on SGX that it had proposed an issue of non-convertible bonds and warrants that would be sold to Hong Kong-based brokerage SHK Securities (the deal was eventually completed on 8 July 2013).

Under the agreement between SHK and Eratat, the former would purchase bonds, which would come due on June 2015, from the latter at a price of RMB100.5m. In addition, the interest payments for the bond would amount to RMB16.75m per year, bringing the effective interest rate on the bonds to 16.67% per year!

Even without any reference, that’s an unduly high amount of interest to be paid for a bond that has a maturity of only 2 years. Usually, bonds with higher interests are ones with longer maturity dates, in which the long time-span from issue-to-maturity would mean that the creditor is exposed to more risks.

The bond issue by Eratat comes with 82.5m warrants that can be converted into shares of the apparel company at an exercise price of S$0.25 each. If the warrants were fully converted into shares, the entire bond-cum-warrant-issue-exercise would net Eratat RMB200.8m in proceeds (with roughly half of the total proceeds coming from the bond issue alone).

Management has the intention to use the proceeds from the bond issue itself for working capital needs in addition to the setting up of offices, showrooms, and shops in Shanghai. As for the additional money that would come in if the warrants were exercised, it’s earmarked for “working capital purposes, or to effect repayment of the Bonds upon redemption, as the [c]ompany sees fit.”

But here’s where it gets interesting. Prior to the bond issue, Eratat’s latest financials showed that it had cash on hand of RMB545m with zero debt. This meant that it could have used its cash hoard, without undue stress on its finances, to fund the corporate activities that were just mentioned instead of relying on expensive debt.

But as we know, Eratat decided to take on costly debt to “strengthen its financial position” despite management acknowledging the fact that the company has sufficient working capital for its needs.

Eratat’s annual interest payment of RMB16.75m for its bonds makes up almost 12% of its profit of RMB142 for the whole of last year showing how the bond issue isn’t exactly a shareholder friendly move as the interest payments are added expenses that might lower the company’s profits substantially.

Foolish Bottom Line

Companies issuing debt are a dime a dozen. Most of the time, these activities are needed for companies to access crucial funding for business opportunities, or to benefit shareholders similar to what CapitaLand did.

But, there are also times when some companies’ managements make decidedly boneheaded moves where the benefits to shareholders are either unclear or just not present at all. In such cases, investors have to ask themselves if their investment theses in such companies are still intact.

Click here now  for your  FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by  David Kuo ,   Take Stock Singapore  tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook  to keep up-to-date with our latest news and articles.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.