We Think Chemfab Alkalis (NSE:CHEMFAB) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Chemfab Alkalis Limited (NSE:CHEMFAB) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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.

Check out our latest analysis for Chemfab Alkalis

What Is Chemfab Alkalis's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2020 Chemfab Alkalis had debt of ₹422.1m, up from ₹339.9m in one year. However, it does have ₹8.64m in cash offsetting this, leading to net debt of about ₹413.5m.

How Healthy Is Chemfab Alkalis's Balance Sheet?

According to the last reported balance sheet, Chemfab Alkalis had liabilities of ₹490.2m due within 12 months, and liabilities of ₹238.2m due beyond 12 months. Offsetting this, it had ₹8.64m in cash and ₹246.5m in receivables that were due within 12 months. So it has liabilities totalling ₹473.3m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Chemfab Alkalis has a market capitalization of ₹1.97b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chemfab Alkalis's net debt is only 0.87 times its EBITDA. And its EBIT easily covers its interest expense, being 15.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Chemfab Alkalis's load is not too heavy, because its EBIT was down 58% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chemfab Alkalis's earnings that will influence how the balance sheet holds up in the future. 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 always check how much of that EBIT is translated into free cash flow. Considering the last three years, Chemfab Alkalis actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Neither Chemfab Alkalis's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Chemfab Alkalis's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Chemfab Alkalis is showing 2 warning signs 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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