The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘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. As with many other companies. Bhagyanagar India Limited (NSE:BHAGYNAGAR) makes use of debt. 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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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.
How Much Debt Does Bhagyanagar India Carry?
The image below, which you can click on for greater detail, shows that at March 2019 Bhagyanagar India had debt of ₹957.4m, up from ₹456.4m in one year. However, because it has a cash reserve of ₹40.3m, its net debt is less, at about ₹917.1m.
A Look At Bhagyanagar India’s Liabilities
According to the last reported balance sheet, Bhagyanagar India had liabilities of ₹1.10b due within 12 months, and liabilities of ₹96.4m due beyond 12 months. On the other hand, it had cash of ₹40.3m and ₹388.6m worth of receivables due within a year. So its liabilities total ₹765.8m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s ₹671.9m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Since Bhagyanagar India does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While we wouldn’t blink an eye at Bhagyanagar India’s net debt to EBITDA ratio of 4.83, we think its super-low interest cover of 2.00 times is a bad sign. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, Bhagyanagar India boosted its EBIT by a silky 70% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing 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 Bhagyanagar India will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Bhagyanagar India generated free cash flow amounting to a very robust 93% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
While Bhagyanagar India’s interest cover has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. We think that Bhagyanagar India’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Bhagyanagar India insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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