Is Pricol (NSE:PRICOLLTD) 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.' 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 Pricol Limited (NSE:PRICOLLTD) makes use of debt. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Pricol

What Is Pricol's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Pricol had debt of ₹3.20b, up from ₹1.74b in one year. However, it also had ₹508.5m in cash, and so its net debt is ₹2.69b.

A Look At Pricol's Liabilities

The latest balance sheet data shows that Pricol had liabilities of ₹5.10b due within a year, and liabilities of ₹3.13b falling due after that. Offsetting this, it had ₹508.5m in cash and ₹2.12b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹5.60b.

This is a mountain of leverage relative to its market capitalization of ₹5.68b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

While Pricol has a quite reasonable net debt to EBITDA multiple of 2.5, its interest cover seems weak, at 0.57. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Pleasingly, Pricol is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 100% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Pricol's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Pricol recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over Pricol's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Pricol's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For instance, we've identified 4 warning signs for Pricol (1 is potentially serious) 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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