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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Murudeshwar Ceramics Limited (NSE:MURUDCERA) does carry debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Murudeshwar Ceramics’s Debt?
The image below, which you can click on for greater detail, shows that Murudeshwar Ceramics had debt of ₹955.9m at the end of March 2019, a reduction from ₹1.04b over a year. On the flip side, it has ₹30.3m in cash leading to net debt of about ₹925.6m.
A Look At Murudeshwar Ceramics’s Liabilities
Zooming in on the latest balance sheet data, we can see that Murudeshwar Ceramics had liabilities of ₹975.1m due within 12 months and liabilities of ₹429.3m due beyond that. Offsetting these obligations, it had cash of ₹30.3m as well as receivables valued at ₹639.2m due within 12 months. So its liabilities total ₹734.9m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of ₹780.2m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Because it carries more debt than cash, we think it’s worth watching Murudeshwar Ceramics’s balance sheet over time.
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.
While we wouldn’t blink an eye at Murudeshwar Ceramics’s net debt to EBITDA ratio of 3.21, we think its super-low interest cover of 1.22 times is a bad sign. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Another concern for investors might be that Murudeshwar Ceramics’s EBIT fell 12% in the last year. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Murudeshwar Ceramics will need earnings to service that debt. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Murudeshwar Ceramics reported free cash flow worth 3.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over Murudeshwar Ceramics’s attempt at covering its interest expense with its EBIT, we’re certainly not enthusiastic. And furthermore, its level of total liabilities also fails to instill confidence. We’re quite clear that we consider Murudeshwar Ceramics to be really rather risky, as a result of its debt. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Murudeshwar Ceramics’s earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.