Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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. We note that MMP Industries Limited (NSE:MMP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is MMP Industries’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 MMP Industries had debt of ₹162.7m, up from ₹375 in one year. But it also has ₹385.0m in cash to offset that, meaning it has ₹222.4m net cash.
A Look At MMP Industries’s Liabilities
Zooming in on the latest balance sheet data, we can see that MMP Industries had liabilities of ₹391.3m due within 12 months and liabilities of ₹75.9m due beyond that. Offsetting this, it had ₹385.0m in cash and ₹518.3m in receivables that were due within 12 months. So it can boast ₹436.0m more liquid assets than total liabilities.
This surplus suggests that MMP Industries is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that MMP Industries has more cash than debt is arguably a good indication that it can manage its debt safely.
MMP Industries’s EBIT was pretty flat over the last year, but that shouldn’t be an issue given the it doesn’t have a lot of debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since MMP 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While MMP Industries has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Considering the last three years, MMP Industries actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While we empathize with investors who find debt concerning, you should keep in mind that MMP Industries has net cash of ₹222.4m, as well as more liquid assets than liabilities. So we don’t have any problem with MMP Industries’s use of debt. 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. To that end, you should learn about the 3 warning signs we’ve spotted with MMP Industries (including 1 which is is significant) .
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.
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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