Is PPAP Automotive (NSE:PPAP) Using Too Much Debt?

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.' 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 can see that PPAP Automotive Limited (NSE:PPAP) does use debt in its business. But the real question is whether this debt is making the company risky.

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 PPAP Automotive

How Much Debt Does PPAP Automotive Carry?

As you can see below, at the end of March 2022, PPAP Automotive had ₹1.08b of debt, up from ₹521.7m a year ago. Click the image for more detail. On the flip side, it has ₹32.7m in cash leading to net debt of about ₹1.05b.

A Look At PPAP Automotive's Liabilities

We can see from the most recent balance sheet that PPAP Automotive had liabilities of ₹1.03b falling due within a year, and liabilities of ₹921.6m due beyond that. Offsetting this, it had ₹32.7m in cash and ₹571.1m in receivables that were due within 12 months. So its liabilities total ₹1.35b more than the combination of its cash and short-term receivables.

PPAP Automotive has a market capitalization of ₹2.91b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 PPAP Automotive's net debt to EBITDA ratio of 2.7, we think its super-low interest cover of 1.4 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that PPAP Automotive grew its EBIT a smooth 42% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since PPAP Automotive 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, PPAP Automotive burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither PPAP Automotive's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that PPAP Automotive is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for PPAP Automotive you should be aware of, and 2 of them are a bit concerning.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.