Sundaram-Clayton (NSE:SUNCLAYLTD) Seems To Be Using A Lot Of 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.' 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 note that Sundaram-Clayton Limited (NSE:SUNCLAYLTD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Sundaram-Clayton

What Is Sundaram-Clayton's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sundaram-Clayton had ₹125.7b of debt, an increase on ₹109.8b, over one year. However, it also had ₹19.3b in cash, and so its net debt is ₹106.3b.

A Look At Sundaram-Clayton's Liabilities

The latest balance sheet data shows that Sundaram-Clayton had liabilities of ₹112.4b due within a year, and liabilities of ₹66.1b falling due after that. Offsetting these obligations, it had cash of ₹19.3b as well as receivables valued at ₹68.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹91.0b.

Given this deficit is actually higher than the company's market capitalization of ₹70.5b, we think shareholders really should watch Sundaram-Clayton'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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Sundaram-Clayton like a one-two punch to the gut. The debt burden here is substantial. Worse, Sundaram-Clayton's EBIT was down 20% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. 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 that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Sundaram-Clayton's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering all the factors previously mentioned, we think that Sundaram-Clayton really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Sundaram-Clayton (of which 2 are a bit concerning!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. 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.
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