Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Varroc Engineering Limited (NSE:VARROC) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Varroc Engineering's Debt?
As you can see below, at the end of September 2021, Varroc Engineering had ₹40.5b of debt, up from ₹27.1b a year ago. Click the image for more detail. However, it does have ₹3.52b in cash offsetting this, leading to net debt of about ₹36.9b.
How Healthy Is Varroc Engineering's Balance Sheet?
We can see from the most recent balance sheet that Varroc Engineering had liabilities of ₹64.6b falling due within a year, and liabilities of ₹21.7b due beyond that. Offsetting this, it had ₹3.52b in cash and ₹16.2b in receivables that were due within 12 months. So its liabilities total ₹66.6b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of ₹49.6b, we think shareholders really should watch Varroc Engineering's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Varroc Engineering can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Over 12 months, Varroc Engineering reported revenue of ₹127b, which is a gain of 22%, although it did not report any earnings before interest and tax. Shareholders probably have their fingers crossed that it can grow its way to profits.
Even though Varroc Engineering managed to grow its top line quite deftly, the cold hard truth is that it is losing money on the EBIT line. Indeed, it lost a very considerable ₹7.3b at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of ₹5.1b over the last twelve months. That means it's on the risky side of things. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Varroc Engineering (1 is significant) you should be aware of.
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.
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.