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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Power & Instrumentation (Gujarat) Limited (NSE:PIGL) does carry debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Power & Instrumentation (Gujarat)'s Net Debt?
As you can see below, at the end of September 2021, Power & Instrumentation (Gujarat) had ₹214.8m of debt, up from ₹140.8m a year ago. Click the image for more detail. However, it does have ₹60.3m in cash offsetting this, leading to net debt of about ₹154.5m.
How Strong Is Power & Instrumentation (Gujarat)'s Balance Sheet?
According to the last reported balance sheet, Power & Instrumentation (Gujarat) had liabilities of ₹322.4m due within 12 months, and liabilities of ₹50.4m due beyond 12 months. On the other hand, it had cash of ₹60.3m and ₹537.5m worth of receivables due within a year. So it can boast ₹224.9m more liquid assets than total liabilities.
This excess liquidity is a great indication that Power & Instrumentation (Gujarat)'s balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master.
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.
Power & Instrumentation (Gujarat) has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.5 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. The bad news is that Power & Instrumentation (Gujarat) saw its EBIT decline by 19% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But it is Power & Instrumentation (Gujarat)'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Power & Instrumentation (Gujarat) saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither Power & Instrumentation (Gujarat)'s ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to handle its total liabilities with ease. We think that Power & Instrumentation (Gujarat)'s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Power & Instrumentation (Gujarat) has 4 warning signs (and 3 which are a bit concerning) we think you should know about.
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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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.