Here's Why JK Tyre & Industries (NSE:JKTYRE) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, JK Tyre & Industries Limited (NSE:JKTYRE) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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.

Check out our latest analysis for JK Tyre & Industries

What Is JK Tyre & Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that JK Tyre & Industries had ₹47.8b of debt in March 2023, down from ₹51.2b, one year before. However, it does have ₹2.77b in cash offsetting this, leading to net debt of about ₹45.1b.

A Look At JK Tyre & Industries' Liabilities

We can see from the most recent balance sheet that JK Tyre & Industries had liabilities of ₹52.6b falling due within a year, and liabilities of ₹36.9b due beyond that. Offsetting these obligations, it had cash of ₹2.77b as well as receivables valued at ₹23.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹62.8b.

Given this deficit is actually higher than the company's market capitalization of ₹51.5b, we think shareholders really should watch JK Tyre & Industries's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

While we wouldn't worry about JK Tyre & Industries's net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 2.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On a lighter note, we note that JK Tyre & Industries grew its EBIT by 29% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine JK Tyre & Industries's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, JK Tyre & Industries generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

While JK Tyre & Industries's interest cover has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that JK Tyre & Industries is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for JK Tyre & Industries (1 is significant) you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.