Stock Analysis

These 4 Measures Indicate That Apollo Tyres (NSE:APOLLOTYRE) Is Using Debt Extensively

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NSEI:APOLLOTYRE
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Apollo Tyres Limited (NSE:APOLLOTYRE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

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What Is Apollo Tyres's Net Debt?

The chart below, which you can click on for greater detail, shows that Apollo Tyres had ₹62.9b in debt in September 2022; about the same as the year before. However, because it has a cash reserve of ₹8.25b, its net debt is less, at about ₹54.7b.

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NSEI:APOLLOTYRE Debt to Equity History December 2nd 2022

A Look At Apollo Tyres' Liabilities

According to the last reported balance sheet, Apollo Tyres had liabilities of ₹74.8b due within 12 months, and liabilities of ₹70.0b due beyond 12 months. Offsetting this, it had ₹8.25b in cash and ₹17.8b in receivables that were due within 12 months. So its liabilities total ₹118.7b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Apollo Tyres is worth ₹200.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Apollo Tyres has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. The bad news is that Apollo Tyres saw its EBIT decline by 20% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Apollo Tyres can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Apollo Tyres recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Apollo Tyres's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Looking at the bigger picture, it seems clear to us that Apollo Tyres's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should be aware of the 2 warning signs we've spotted with Apollo Tyres .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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