Hind Rectifiers (NSE:HIRECT) Takes On Some Risk With Its Use Of 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hind Rectifiers Limited (NSE:HIRECT) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hind Rectifiers

How Much Debt Does Hind Rectifiers Carry?

As you can see below, at the end of September 2020, Hind Rectifiers had ₹753.9m of debt, up from ₹693.6m a year ago. Click the image for more detail. On the flip side, it has ₹179.0m in cash leading to net debt of about ₹574.9m.

How Strong Is Hind Rectifiers' Balance Sheet?

We can see from the most recent balance sheet that Hind Rectifiers had liabilities of ₹1.27b falling due within a year, and liabilities of ₹181.5m due beyond that. Offsetting these obligations, it had cash of ₹179.0m as well as receivables valued at ₹898.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹369.3m.

Of course, Hind Rectifiers has a market capitalization of ₹2.77b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Hind Rectifiers's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 2.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that Hind Rectifiers's EBIT was down 38% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Hind Rectifiers'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hind Rectifiers burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Hind Rectifiers's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Looking at the bigger picture, it seems clear to us that Hind Rectifiers's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example, we've discovered 5 warning signs for Hind Rectifiers (1 can't be ignored!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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