Is Mahindra EPC Irrigation (NSE:MAHEPC) 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. Importantly, Mahindra EPC Irrigation Limited (NSE:MAHEPC) does carry 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Mahindra EPC Irrigation

What Is Mahindra EPC Irrigation's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2020 Mahindra EPC Irrigation had debt of ₹130.0m, up from ₹34.2m in one year. However, it also had ₹111.1m in cash, and so its net debt is ₹18.9m.

How Healthy Is Mahindra EPC Irrigation's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Mahindra EPC Irrigation had liabilities of ₹928.6m due within 12 months and liabilities of ₹4.00m due beyond that. Offsetting this, it had ₹111.1m in cash and ₹1.30b in receivables that were due within 12 months. So it can boast ₹475.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Mahindra EPC Irrigation could probably pay off its debt with ease, as its balance sheet is far from stretched. Carrying virtually no net debt, Mahindra EPC Irrigation has a very light debt load indeed.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Mahindra EPC Irrigation has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.053 and EBIT of 22.5 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On top of that, Mahindra EPC Irrigation grew its EBIT by 77% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Mahindra EPC Irrigation will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Mahindra EPC Irrigation 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

The good news is that Mahindra EPC Irrigation's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at the bigger picture, we think Mahindra EPC Irrigation's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Case in point: We've spotted 2 warning signs for Mahindra EPC Irrigation you should be aware of.

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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