Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies The Indian Hume Pipe Company Limited (NSE:INDIANHUME) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Indian Hume Pipe's Debt?
The image below, which you can click on for greater detail, shows that Indian Hume Pipe had debt of ₹6.00b at the end of September 2020, a reduction from ₹6.95b over a year. On the flip side, it has ₹377.1m in cash leading to net debt of about ₹5.62b.
How Strong Is Indian Hume Pipe's Balance Sheet?
According to the last reported balance sheet, Indian Hume Pipe had liabilities of ₹12.7b due within 12 months, and liabilities of ₹1.26b due beyond 12 months. Offsetting these obligations, it had cash of ₹377.1m as well as receivables valued at ₹5.22b due within 12 months. So its liabilities total ₹8.35b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₹9.14b, so it does suggest shareholders should keep an eye on Indian Hume Pipe's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Indian Hume Pipe's net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 1.9 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Indian Hume Pipe's EBIT was down 28% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Indian Hume Pipe 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Indian Hume Pipe recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On the face of it, Indian Hume Pipe's interest cover 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. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Indian Hume Pipe has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Indian Hume Pipe (of which 1 shouldn't be ignored!) you should know about.
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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