We Think Patel Engineering (NSE:PATELENG) Is Taking Some Risk With Its Debt

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. As with many other companies Patel Engineering Limited (NSE:PATELENG) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Patel Engineering

What Is Patel Engineering's Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Patel Engineering had debt of ₹23.8b, up from ₹22.2b in one year. However, it does have ₹1.89b in cash offsetting this, leading to net debt of about ₹21.9b.

How Strong Is Patel Engineering's Balance Sheet?

According to the last reported balance sheet, Patel Engineering had liabilities of ₹35.8b due within 12 months, and liabilities of ₹23.8b due beyond 12 months. On the other hand, it had cash of ₹1.89b and ₹5.12b worth of receivables due within a year. So its liabilities total ₹52.6b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₹13.0b 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, Patel Engineering would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Patel Engineering's debt to EBITDA ratio (4.8) suggests that it uses some debt, its interest cover is very weak, at 1.3, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that Patel Engineering actually grew its EBIT by a hefty 1,553%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Patel Engineering 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Patel Engineering actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We feel some trepidation about Patel Engineering's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Patel Engineering is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Patel Engineering is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.