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. 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. We note that Berger Paints India Limited (NSE:BERGEPAINT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Berger Paints India’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Berger Paints India had ₹5.12b of debt, an increase on ₹4.22b, over one year. On the flip side, it has ₹4.84b in cash leading to net debt of about ₹280.5m.
How Strong Is Berger Paints India’s Balance Sheet?
We can see from the most recent balance sheet that Berger Paints India had liabilities of ₹15.3b falling due within a year, and liabilities of ₹3.53b due beyond that. On the other hand, it had cash of ₹4.84b and ₹7.26b worth of receivables due within a year. So it has liabilities totalling ₹6.77b more than its cash and near-term receivables, combined.
Having regard to Berger Paints India’s size, it seems that its liquid assets are well balanced with its total liabilities. So it’s very unlikely that the ₹464.5b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Berger Paints India has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
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). 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).
With debt at a measly 0.029 times EBITDA and EBIT covering interest a whopping 51.8 times, it’s clear that Berger Paints India is not a desperate borrower. So relative to past earnings, the debt load seems trivial. Also good is that Berger Paints India grew its EBIT at 15% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Berger Paints India’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. Looking at the most recent three years, Berger Paints India recorded free cash flow of 25% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Berger Paints India’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Berger Paints India takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Berger Paints India insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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