Gillanders Arbuthnot (NSE:GILLANDERS) Seems To Be Using An Awful Lot Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Gillanders Arbuthnot and Company Limited (NSE:GILLANDERS) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Gillanders Arbuthnot

How Much Debt Does Gillanders Arbuthnot Carry?

The image below, which you can click on for greater detail, shows that Gillanders Arbuthnot had debt of ₹2.93b at the end of March 2020, a reduction from ₹3.92b over a year. However, because it has a cash reserve of ₹1.03b, its net debt is less, at about ₹1.89b.

How Healthy Is Gillanders Arbuthnot's Balance Sheet?

The latest balance sheet data shows that Gillanders Arbuthnot had liabilities of ₹4.49b due within a year, and liabilities of ₹1.32b falling due after that. On the other hand, it had cash of ₹1.03b and ₹829.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹3.94b.

The deficiency here weighs heavily on the ₹614.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Gillanders Arbuthnot would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Gillanders Arbuthnot's net debt to EBITDA ratio of 4.2, we think its super-low interest cover of 0.54 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Gillanders Arbuthnot's EBIT was down 45% 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. There's no doubt that we learn most about debt from the balance sheet. But it is Gillanders Arbuthnot's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Gillanders Arbuthnot actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, Gillanders Arbuthnot'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. Overall, it seems to us that Gillanders Arbuthnot's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Gillanders Arbuthnot (including 1 which is makes us a bit uncomfortable) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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