Here's Why Shankara Building Products (NSE:SHANKARA) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Shankara Building Products Limited (NSE:SHANKARA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shankara Building Products

What Is Shankara Building Products's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 Shankara Building Products had ₹2.41b of debt, an increase on ₹1.97b, over one year. However, it also had ₹135.0m in cash, and so its net debt is ₹2.27b.

How Healthy Is Shankara Building Products's Balance Sheet?

We can see from the most recent balance sheet that Shankara Building Products had liabilities of ₹6.24b falling due within a year, and liabilities of ₹435.7m due beyond that. Offsetting these obligations, it had cash of ₹135.0m as well as receivables valued at ₹4.29b due within 12 months. So it has liabilities totalling ₹2.2b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shankara Building Products is worth ₹8.29b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

While Shankara Building Products has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 2.3. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. One way Shankara Building Products could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shankara Building Products's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. In the last three years, Shankara Building Products's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Shankara Building Products's struggle to cover its interest expense with its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. We think that Shankara Building Products's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shankara Building Products is showing 3 warning signs in our investment analysis , and 2 of those can't be ignored...

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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