Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Patspin India Limited (NSE:PATSPINLTD) does carry 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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Patspin India’s Net Debt?
The image below, which you can click on for greater detail, shows that Patspin India had debt of ₹1.81b at the end of March 2019, a reduction from ₹2.07b over a year. However, it also had ₹106.4m in cash, and so its net debt is ₹1.70b.
How Strong Is Patspin India’s Balance Sheet?
According to the last reported balance sheet, Patspin India had liabilities of ₹2.18b due within 12 months, and liabilities of ₹713.2m due beyond 12 months. Offsetting these obligations, it had cash of ₹106.4m as well as receivables valued at ₹606.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.18b.
The deficiency here weighs heavily on the ₹225.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet.” So we definitely think shareholders need to watch this one closely. At the end of the day, Patspin India would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.69 times and a disturbingly high net debt to EBITDA ratio of 5.6 hit our confidence in Patspin India like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. On a lighter note, we note that Patspin India grew its EBIT by 21% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Patspin India 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Patspin India actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Patspin India’s interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Patspin India stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Even though Patspin India lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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