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. Importantly, Umang Dairies Limited (NSE:UMANGDAIRY) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Umang Dairies Carry?
The image below, which you can click on for greater detail, shows that Umang Dairies had debt of ₹140.9m at the end of September 2019, a reduction from ₹281.0m over a year. However, it does have ₹25.5m in cash offsetting this, leading to net debt of about ₹115.4m.
How Strong Is Umang Dairies’s Balance Sheet?
According to the last reported balance sheet, Umang Dairies had liabilities of ₹367.4m due within 12 months, and liabilities of ₹265.5m due beyond 12 months. On the other hand, it had cash of ₹25.5m and ₹82.6m worth of receivables due within a year. So its liabilities total ₹524.9m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Umang Dairies has a market capitalization of ₹931.8m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 1.1 and interest cover of 3.6 times, it seems to us that Umang Dairies 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. Importantly, Umang Dairies’s EBIT fell a jaw-dropping 52% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Umang Dairies will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Umang Dairies reported free cash flow worth 8.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
We’d go so far as to say Umang Dairies’s EBIT growth rate was disappointing. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that Umang Dairies has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 4 warning signs with Umang Dairies (at least 1 which shouldn’t be ignored) , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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