Is Creative Newtech (NSE:CREATIVE) Using Too Much Debt?

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. We note that Creative Newtech Limited (NSE:CREATIVE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Creative Newtech

What Is Creative Newtech's Net Debt?

The image below, which you can click on for greater detail, shows that Creative Newtech had debt of ₹696.3m at the end of September 2023, a reduction from ₹727.3m over a year. However, it also had ₹240.4m in cash, and so its net debt is ₹455.9m.

How Healthy Is Creative Newtech's Balance Sheet?

According to the last reported balance sheet, Creative Newtech had liabilities of ₹1.27b due within 12 months, and liabilities of ₹91.5m due beyond 12 months. Offsetting this, it had ₹240.4m in cash and ₹1.35b in receivables that were due within 12 months. So it can boast ₹230.7m more liquid assets than total liabilities.

This short term liquidity is a sign that Creative Newtech could probably pay off its debt with ease, as its balance sheet is far from stretched.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Creative Newtech's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably Creative Newtech's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is Creative Newtech's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Creative Newtech 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

Creative Newtech's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Creative Newtech is a somewhat risky investment as a result of its debt. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Creative Newtech you should be aware of, and 1 of them is concerning.

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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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.