These 4 Measures Indicate That KNR Constructions (NSE:KNRCON) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, KNR Constructions Limited (NSE:KNRCON) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for KNR Constructions

What Is KNR Constructions's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 KNR Constructions had debt of ₹8.13b, up from ₹7.31b in one year. However, it also had ₹3.24b in cash, and so its net debt is ₹4.89b.

How Strong Is KNR Constructions's Balance Sheet?

We can see from the most recent balance sheet that KNR Constructions had liabilities of ₹9.16b falling due within a year, and liabilities of ₹7.96b due beyond that. Offsetting this, it had ₹3.24b in cash and ₹1.69b in receivables that were due within 12 months. So its liabilities total ₹12.2b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because KNR Constructions is worth ₹46.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 KNR Constructions's low debt to EBITDA ratio of 0.75 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We note that KNR Constructions grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine KNR Constructions's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, KNR Constructions burned a lot of cash. 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

Based on what we've seen KNR Constructions is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. Looking at all this data makes us feel a little cautious about KNR Constructions's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 3 warning signs we've spotted with KNR Constructions (including 2 which are potentially serious) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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