Is Ambika Cotton Mills (NSE:AMBIKCO) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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. Importantly, Ambika Cotton Mills Limited (NSE:AMBIKCO) does carry debt. 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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Ambika Cotton Mills

What Is Ambika Cotton Mills's Debt?

The image below, which you can click on for greater detail, shows that Ambika Cotton Mills had debt of ₹694.3m at the end of March 2020, a reduction from ₹886.7m over a year. However, it does have ₹290.0m in cash offsetting this, leading to net debt of about ₹404.3m.

A Look At Ambika Cotton Mills's Liabilities

According to the last reported balance sheet, Ambika Cotton Mills had liabilities of ₹900.5m due within 12 months, and liabilities of ₹300.7m due beyond 12 months. On the other hand, it had cash of ₹290.0m and ₹181.2m worth of receivables due within a year. So it has liabilities totalling ₹730.0m more than its cash and near-term receivables, combined.

Given Ambika Cotton Mills has a market capitalization of ₹3.92b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ambika Cotton Mills has net debt of just 0.38 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.3 times, which is more than adequate. The modesty of its debt load may become crucial for Ambika Cotton Mills if management cannot prevent a repeat of the 22% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is Ambika Cotton Mills's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Ambika Cotton Mills recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While Ambika Cotton Mills's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Ambika Cotton Mills's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 3 warning signs we've spotted with Ambika Cotton Mills (including 1 which is shouldn't be ignored) .

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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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