Here's Why Gillanders Arbuthnot (NSE:GILLANDERS) Has A Meaningful Debt Burden

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.' 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 can see that Gillanders Arbuthnot and Company Limited (NSE:GILLANDERS) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Gillanders Arbuthnot

How Much Debt Does Gillanders Arbuthnot Carry?

The image below, which you can click on for greater detail, shows that Gillanders Arbuthnot had debt of ₹1.86b at the end of March 2021, a reduction from ₹3.66b over a year. On the flip side, it has ₹795.6m in cash leading to net debt of about ₹1.06b.

How Strong Is Gillanders Arbuthnot's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Gillanders Arbuthnot had liabilities of ₹2.81b due within 12 months and liabilities of ₹902.0m due beyond that. On the other hand, it had cash of ₹795.6m and ₹651.7m worth of receivables due within a year. So it has liabilities totalling ₹2.27b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₹1.17b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Gillanders Arbuthnot would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

While we wouldn't worry about Gillanders Arbuthnot's net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 0.39 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, Gillanders Arbuthnot boosted its EBIT by a silky 38% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Gillanders Arbuthnot's earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Gillanders Arbuthnot actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

While Gillanders Arbuthnot's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Gillanders Arbuthnot's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. 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 Gillanders Arbuthnot you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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