Here's Why Varroc Engineering (NSE:VARROC) Is Weighed Down By Its Debt Load

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. As with many other companies Varroc Engineering Limited (NSE:VARROC) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Varroc Engineering

How Much Debt Does Varroc Engineering Carry?

The image below, which you can click on for greater detail, shows that Varroc Engineering had debt of ₹15.5b at the end of March 2022, a reduction from ₹30.0b over a year. However, because it has a cash reserve of ₹1.18b, its net debt is less, at about ₹14.4b.

How Strong Is Varroc Engineering's Balance Sheet?

We can see from the most recent balance sheet that Varroc Engineering had liabilities of ₹30.3b falling due within a year, and liabilities of ₹59.5b due beyond that. Offsetting this, it had ₹1.18b in cash and ₹5.18b in receivables that were due within 12 months. So its liabilities total ₹83.5b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the ₹46.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Varroc Engineering would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Varroc Engineering has a very low debt to EBITDA ratio of 1.4 so it is strange to see weak interest coverage, with last year's EBIT being only 0.46 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Varroc Engineering made a loss at the EBIT level, last year, but improved that to positive EBIT of ₹548m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Varroc Engineering's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Varroc Engineering 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

On the face of it, Varroc Engineering's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Varroc Engineering has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Varroc Engineering (of which 1 is a bit concerning!) you should know about.

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.