Is Orient Abrasives (NSE:ORIENTABRA) 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. We note that Orient Abrasives Limited (NSE:ORIENTABRA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Orient Abrasives

What Is Orient Abrasives's Debt?

You can click the graphic below for the historical numbers, but it shows that Orient Abrasives had ₹560.3m of debt in March 2020, down from ₹722.3m, one year before. On the flip side, it has ₹122.0m in cash leading to net debt of about ₹438.3m.

A Look At Orient Abrasives's Liabilities

The latest balance sheet data shows that Orient Abrasives had liabilities of ₹963.7m due within a year, and liabilities of ₹189.3m falling due after that. Offsetting these obligations, it had cash of ₹122.0m as well as receivables valued at ₹931.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹100.0m.

Given Orient Abrasives has a market capitalization of ₹2.69b, 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). 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).

Looking at its net debt to EBITDA of 1.2 and interest cover of 3.0 times, it seems to us that Orient Abrasives is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Orient Abrasives's EBIT flopped 15% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But it is Orient Abrasives'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Orient Abrasives recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Orient Abrasives's EBIT growth rate and its interest cover were discouraging. At least its net debt to EBITDA gives us reason to be optimistic. We think that Orient Abrasives's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Orient Abrasives is showing 3 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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