Let’s look at the most basic of accounting equations (simplified)
Shareholder equity + Net Liabilities = Net assets
Net liabilities in this case are the on-balance sheet items such as debt, Account payables etc. In addition, there are also some off-balance sheet items such as contractual lease payment, accrued compensation etc. On the asset side, we have the obvious assets such as fixed assets, current assets and cash.
It’s an axiom or truth that the above equation needs to balance out. However, the Indian markets have long violated this axiom. There have been several instances where promoters created dubious or nonexistent assets via debt, defaulted on the debt and were still able to keep equity/ control in the firm.
This is slowly becoming a thing of the past.
The recent introduction of IBC and formation of the NCLT, means that once a company defaults on its debt, the debt holder can take the company to the bankruptcy court. Once that happens, the court can liquidate the firm (sell all the assets) and re-pay the debt holder. Whatever is left after paying all the debt and other claimants, is available to the equity owner.
In the past, the promoter could arm twist the debt holders and thus retain the value of equity. This is no longer possible now.
The 1934 edition of security analysis by Benjamin graham, long considered the bible of value investing, cover bankruptcy and net asset type of investing in detail. After the 1930s depression in the US, a lot of firms were available for less than net asset value (net value after deducting all liabilities). An enterprising investor could take control of such a company, liquidate all assets (often at a discount) and make more than the amount invested.
Although the concept holds true, that world no longer exists today. Most companies create value based on intangibles such as customer relationship/ brands etc. The tangible assets on the book are not worth much as standalone assets and even less in a fire sale. In most bankruptcy proceeding such assets sell for 20-30% of book value.
There have been exceptions to the above in case of some steel companies where assets have sold for 60%+. If you take most other companies in bankruptcy proceedings such as Jet airways, the assets on the book will fetch not more than 30-40% of their value.
If the above numbers are valid, then in most cases, the debt holder takes a haircut and is able to make 40-50 cents on the dollar if the business remains in operation (under a different management). If the business is liquidated, then the recovery is even less.
In all these cases, the equity holder gets nothing at all.
