Does Somany Ceramics (NSE:SOMANYCERA) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Somany Ceramics Limited (NSE:SOMANYCERA) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Somany Ceramics

What Is Somany Ceramics's Debt?

As you can see below, Somany Ceramics had ₹4.98b of debt at March 2020, down from ₹5.74b a year prior. However, it does have ₹516.0m in cash offsetting this, leading to net debt of about ₹4.47b.

How Healthy Is Somany Ceramics's Balance Sheet?

The latest balance sheet data shows that Somany Ceramics had liabilities of ₹5.57b due within a year, and liabilities of ₹3.00b falling due after that. Offsetting these obligations, it had cash of ₹516.0m as well as receivables valued at ₹3.37b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹4.7b.

This is a mountain of leverage relative to its market capitalization of ₹6.18b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Somany Ceramics shareholders face the double whammy of a high net debt to EBITDA ratio (5.4), and fairly weak interest coverage, since EBIT is just 0.93 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Somany Ceramics's EBIT was down 73% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Somany Ceramics can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Somany Ceramics reported free cash flow worth 3.4% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Somany Ceramics's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Somany Ceramics has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Somany Ceramics you should be aware of, and 1 of them is a bit unpleasant.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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