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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.' 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. As with many other companies. Harita Seating Systems Limited (NSE:HARITASEAT) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Harita Seating Systems
What Is Harita Seating Systems's Debt?
As you can see below, at the end of March 2019, Harita Seating Systems had ₹316.8m of debt, up from ₹223.7m a year ago. Click the image for more detail. On the flip side, it has ₹159.0m in cash leading to net debt of about ₹157.7m.
A Look At Harita Seating Systems's Liabilities
According to the last reported balance sheet, Harita Seating Systems had liabilities of ₹2.57b due within 12 months, and liabilities of ₹159.9m due beyond 12 months. On the other hand, it had cash of ₹159.0m and ₹1.95b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹627.2m.
Given Harita Seating Systems has a market capitalization of ₹3.27b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Either way, since Harita Seating Systems does have more debt than cash, it's worth keeping an eye on its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Harita Seating Systems has a low net debt to EBITDA ratio of only 0.22. And its EBIT covers its interest expense a whopping 17.3 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Harita Seating Systems's load is not too heavy, because its EBIT was down 23% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is Harita Seating Systems'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Harita Seating Systems 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 and improvement.
Our View
Neither Harita Seating Systems'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 the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Harita Seating Systems is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Harita Seating Systems's earnings per share history for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.