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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Sumit Woods Limited (NSE:SUMIT) does use debt in its business. But the real question is whether this debt is making the company risky.
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, 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 Sumit Woods’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Sumit Woods had ₹367.2m of debt, an increase on ₹316.2m, over one year. But on the other hand it also has ₹371.7m in cash, leading to a ₹4.48m net cash position.
How Strong Is Sumit Woods’s Balance Sheet?
According to the last reported balance sheet, Sumit Woods had liabilities of ₹307.0m due within 12 months, and liabilities of ₹303.4m due beyond 12 months. Offsetting these obligations, it had cash of ₹371.7m as well as receivables valued at ₹81.4m due within 12 months. So it has liabilities totalling ₹157.3m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Sumit Woods is worth ₹370.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Sumit Woods also has more cash than debt, so we’re pretty confident it can manage its debt safely.
Better yet, Sumit Woods grew its EBIT by 195% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sumit Woods’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. Sumit Woods may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Sumit Woods recorded free cash flow of 31% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Although Sumit Woods’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of ₹4.48m. And we liked the look of last year’s 195% year-on-year EBIT growth. So we are not troubled with Sumit Woods’s debt use. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with Sumit Woods (at least 1 which is concerning) , and understanding them should be part of your investment process.
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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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. Thank you for reading.