Is Precision Camshafts (NSE:PRECAM) 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. As with many other companies Precision Camshafts Limited (NSE:PRECAM) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Precision Camshafts

How Much Debt Does Precision Camshafts Carry?

As you can see below, Precision Camshafts had ₹1.19b of debt at September 2022, down from ₹1.47b a year prior. But it also has ₹2.69b in cash to offset that, meaning it has ₹1.50b net cash.

How Healthy Is Precision Camshafts' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Precision Camshafts had liabilities of ₹3.73b due within 12 months and liabilities of ₹437.2m due beyond that. On the other hand, it had cash of ₹2.69b and ₹1.93b worth of receivables due within a year. So it actually has ₹451.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Precision Camshafts could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Precision Camshafts boasts net cash, so it's fair to say it does not have a heavy debt load!

Sadly, Precision Camshafts's EBIT actually dropped 6.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is Precision Camshafts'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Precision Camshafts 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. Over the last two years, Precision Camshafts actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Precision Camshafts has ₹1.50b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 155% of that EBIT to free cash flow, bringing in ₹41m. So we are not troubled with Precision Camshafts's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Precision Camshafts , and understanding them should be part of your investment process.

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.

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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.