Does Pentagon Rubber (NSE:PENTAGON) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Pentagon Rubber Limited (NSE:PENTAGON) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Pentagon Rubber

What Is Pentagon Rubber's Debt?

As you can see below, Pentagon Rubber had ₹136.6m of debt at September 2023, down from ₹167.5m a year prior. On the flip side, it has ₹7.35m in cash leading to net debt of about ₹129.3m.

How Strong Is Pentagon Rubber's Balance Sheet?

The latest balance sheet data shows that Pentagon Rubber had liabilities of ₹90.8m due within a year, and liabilities of ₹80.3m falling due after that. Offsetting these obligations, it had cash of ₹7.35m as well as receivables valued at ₹218.0m due within 12 months. So it can boast ₹54.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Pentagon Rubber could probably pay off its debt with ease, as its balance sheet is far from stretched.

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.

With a debt to EBITDA ratio of 1.9, Pentagon Rubber uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.3 times its interest expenses harmonizes with that theme. Importantly, Pentagon Rubber grew its EBIT by 45% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Pentagon Rubber 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Pentagon Rubber recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Happily, Pentagon Rubber's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Pentagon Rubber can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Pentagon Rubber is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.