Is HPL Electric & Power (NSE:HPL) A Risky Investment?

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 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. As with many other companies HPL Electric & Power Limited (NSE:HPL) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for HPL Electric & Power

What Is HPL Electric & Power's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 HPL Electric & Power had ₹5.74b of debt, an increase on ₹5.26b, over one year. On the flip side, it has ₹808.1m in cash leading to net debt of about ₹4.93b.

How Strong Is HPL Electric & Power's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HPL Electric & Power had liabilities of ₹7.42b due within 12 months and liabilities of ₹766.5m due beyond that. Offsetting these obligations, it had cash of ₹808.1m as well as receivables valued at ₹4.64b due within 12 months. So it has liabilities totalling ₹2.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₹2.37b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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 HPL Electric & Power's debt to EBITDA ratio (3.9) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that HPL Electric & Power saw its EBIT drop by 14% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is HPL Electric & Power'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, HPL Electric & Power 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

To be frank both HPL Electric & Power's conversion of EBIT to free cash flow and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like HPL Electric & Power has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for HPL Electric & Power (of which 2 make us uncomfortable!) you should know about.

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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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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