Is Kirloskar Oil Engines (NSE:KIRLOSENG) Using Too Much 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Kirloskar Oil Engines Limited (NSE:KIRLOSENG) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Kirloskar Oil Engines

What Is Kirloskar Oil Engines's Debt?

As you can see below, at the end of March 2020, Kirloskar Oil Engines had ₹1.49b of debt, up from ₹898.1m a year ago. Click the image for more detail. However, its balance sheet shows it holds ₹5.64b in cash, so it actually has ₹4.15b net cash.

How Strong Is Kirloskar Oil Engines's Balance Sheet?

According to the last reported balance sheet, Kirloskar Oil Engines had liabilities of ₹7.48b due within 12 months, and liabilities of ₹2.69b due beyond 12 months. Offsetting these obligations, it had cash of ₹5.64b as well as receivables valued at ₹7.39b due within 12 months. So it can boast ₹2.87b more liquid assets than total liabilities.

It's good to see that Kirloskar Oil Engines has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Kirloskar Oil Engines has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Kirloskar Oil Engines's load is not too heavy, because its EBIT was down 55% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kirloskar Oil Engines'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Kirloskar Oil Engines may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Kirloskar Oil Engines 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.

Summing up

While it is always sensible to investigate a company's debt, in this case Kirloskar Oil Engines has ₹4.15b in net cash and a decent-looking balance sheet. So while Kirloskar Oil Engines does not have a great balance sheet, it's certainly not too bad. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Kirloskar Oil Engines that you should be aware of.

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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