We Think Aro Granite Industries (NSE:AROGRANITE) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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, Aro Granite Industries Limited (NSE:AROGRANITE) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Aro Granite Industries

What Is Aro Granite Industries's Net Debt?

As you can see below, at the end of September 2020, Aro Granite Industries had ₹1.61b of debt, up from ₹1.52b a year ago. Click the image for more detail. On the flip side, it has ₹208.3m in cash leading to net debt of about ₹1.40b.

How Strong Is Aro Granite Industries' Balance Sheet?

According to the last reported balance sheet, Aro Granite Industries had liabilities of ₹1.52b due within 12 months, and liabilities of ₹616.1m due beyond 12 months. Offsetting these obligations, it had cash of ₹208.3m as well as receivables valued at ₹536.2m due within 12 months. So its liabilities total ₹1.39b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the ₹699.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Aro Granite Industries 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).

Aro Granite Industries has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 5.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Aro Granite Industries grew its EBIT by 38% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Aro Granite Industries will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Aro Granite Industries 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

To be frank both Aro Granite Industries's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Aro Granite Industries's balance sheet is really quite a risk to the business. 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. 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. Case in point: We've spotted 5 warning signs for Aro Granite Industries you should be aware of, and 2 of them don't sit too well with us.

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. 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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