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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Usha Martin Limited (NSE:USHAMART) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Usha Martin Carry?
The image below, which you can click on for greater detail, shows that Usha Martin had debt of ₹5.61b at the end of September 2019, a reduction from ₹32.5b over a year. However, it also had ₹3.23b in cash, and so its net debt is ₹2.37b.
A Look At Usha Martin’s Liabilities
The latest balance sheet data shows that Usha Martin had liabilities of ₹10.5b due within a year, and liabilities of ₹4.02b falling due after that. Offsetting these obligations, it had cash of ₹3.23b as well as receivables valued at ₹3.29b due within 12 months. So its liabilities total ₹8.01b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₹4.89b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Usha Martin would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Usha Martin’s low debt to EBITDA ratio of 0.80 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.2 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, Usha Martin’s EBIT flopped 20% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Usha Martin will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Usha Martin actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
On the face of it, Usha Martin’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Looking at the bigger picture, it seems clear to us that Usha Martin’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Be aware that Usha Martin is showing 4 warning signs in our investment analysis , you should know about…
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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