Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. We can see that The Supreme Industries Limited (NSE:SUPREMEIND) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 think about a company’s use of debt, we first look at cash and debt together.
What Is Supreme Industries’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Supreme Industries had debt of ₹3.02b, up from ₹2.35b in one year. However, because it has a cash reserve of ₹1.24b, its net debt is less, at about ₹1.78b.
A Look At Supreme Industries’s Liabilities
According to the last reported balance sheet, Supreme Industries had liabilities of ₹10.4b due within 12 months, and liabilities of ₹1.40b due beyond 12 months. Offsetting these obligations, it had cash of ₹1.24b as well as receivables valued at ₹4.69b due within 12 months. So its liabilities total ₹5.88b more than the combination of its cash and short-term receivables.
Since publicly traded Supreme Industries shares are worth a total of ₹178.0b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, Supreme Industries 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). 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).
Supreme Industries has a low net debt to EBITDA ratio of only 0.23. And its EBIT easily covers its interest expense, being 23.9 times the size. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Supreme Industries has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Supreme Industries’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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Supreme Industries’s free cash flow amounted to 37% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Supreme Industries’s interest cover was a real positive on this analysis, as was its net debt to EBITDA. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Considering this range of data points, we think Supreme Industries is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 example, we’ve discovered 1 warning sign for Supreme Industries that you should be aware of before investing here.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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