Sutlej Textiles and Industries (NSE:SUTLEJTEX) Seems To Be Using A Lot 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. Importantly, Sutlej Textiles and Industries Limited (NSE:SUTLEJTEX) does carry debt. But the real question is whether this debt is making the company risky.

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Sutlej Textiles and Industries

What Is Sutlej Textiles and Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Sutlej Textiles and Industries had ₹7.61b of debt in March 2020, down from ₹9.23b, one year before. However, it does have ₹656.9m in cash offsetting this, leading to net debt of about ₹6.95b.

How Strong Is Sutlej Textiles and Industries's Balance Sheet?

According to the last reported balance sheet, Sutlej Textiles and Industries had liabilities of ₹6.24b due within 12 months, and liabilities of ₹5.41b due beyond 12 months. On the other hand, it had cash of ₹656.9m and ₹2.62b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹8.4b.

The deficiency here weighs heavily on the ₹3.94b 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, Sutlej Textiles and Industries would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Weak interest cover of 0.099 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Sutlej Textiles and Industries like a one-two punch to the gut. The debt burden here is substantial. Even worse, Sutlej Textiles and Industries saw its EBIT tank 96% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sutlej Textiles and Industries 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Sutlej Textiles and Industries actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Sutlej Textiles and Industries's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Sutlej Textiles and Industries has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Sutlej Textiles and Industries (at least 2 which make us uncomfortable) , 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.
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