Does Kirloskar Electric (NSE:KECL) Have A Healthy Balance Sheet?

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.' 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 Kirloskar Electric Company Limited (NSE:KECL) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Kirloskar Electric

What Is Kirloskar Electric's Debt?

As you can see below, Kirloskar Electric had ₹1.42b of debt at March 2022, down from ₹1.56b a year prior. However, it also had ₹400.2m in cash, and so its net debt is ₹1.02b.

How Healthy Is Kirloskar Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kirloskar Electric had liabilities of ₹4.65b due within 12 months and liabilities of ₹731.3m due beyond that. On the other hand, it had cash of ₹400.2m and ₹394.5m worth of receivables due within a year. So it has liabilities totalling ₹4.59b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₹2.80b 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. After all, Kirloskar Electric would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Kirloskar Electric shareholders face the double whammy of a high net debt to EBITDA ratio (11.4), and fairly weak interest coverage, since EBIT is just 0.18 times the interest expense. The debt burden here is substantial. One redeeming factor for Kirloskar Electric is that it turned last year's EBIT loss into a gain of ₹47m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kirloskar Electric'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Kirloskar Electric actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Kirloskar Electric's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Kirloskar Electric to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example Kirloskar Electric has 4 warning signs (and 1 which is concerning) we think 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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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.