Rupa (NSE:RUPA) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, '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. As with many other companies Rupa & Company Limited (NSE:RUPA) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Rupa

How Much Debt Does Rupa Carry?

As you can see below, Rupa had ₹1.76b of debt at March 2020, down from ₹2.11b a year prior. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Rupa's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rupa had liabilities of ₹3.96b due within 12 months and liabilities of ₹204.7m due beyond that. Offsetting this, it had ₹17.3m in cash and ₹2.59b in receivables that were due within 12 months. So it has liabilities totalling ₹1.56b more than its cash and near-term receivables, combined.

Of course, Rupa has a market capitalization of ₹14.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

While Rupa's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.3 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. But the other side of the story is that Rupa saw its EBIT decline by 7.6% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Rupa 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Rupa reported free cash flow worth 9.8% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both Rupa's conversion of EBIT to free cash flow and its EBIT growth rate were discouraging. At least its net debt to EBITDA gives us reason to be optimistic. We think that Rupa's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Rupa is showing 1 warning sign in our investment analysis , you should know about...

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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