Is Sundaram-Clayton (NSE:SUNCLAYLTD) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Sundaram-Clayton Limited (NSE:SUNCLAYLTD) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sundaram-Clayton

How Much Debt Does Sundaram-Clayton Carry?

The image below, which you can click on for greater detail, shows that at March 2022 Sundaram-Clayton had debt of ₹160.3b, up from ₹125.6b in one year. However, it does have ₹39.0b in cash offsetting this, leading to net debt of about ₹121.3b.

How Healthy Is Sundaram-Clayton's Balance Sheet?

The latest balance sheet data shows that Sundaram-Clayton had liabilities of ₹146.0b due within a year, and liabilities of ₹86.7b falling due after that. Offsetting this, it had ₹39.0b in cash and ₹94.5b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹99.1b.

When you consider that this deficiency exceeds the company's ₹90.8b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Sundaram-Clayton's net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 2.4 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On the other hand, Sundaram-Clayton grew its EBIT by 21% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sundaram-Clayton'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sundaram-Clayton saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Mulling over Sundaram-Clayton's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Sundaram-Clayton to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 2 warning signs for Sundaram-Clayton (1 is potentially serious!) that you should be aware of before investing here.

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.