Pitti Engineering (NSE:PITTIENG) Seems To Be Using A Lot Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Pitti Engineering Limited (NSE:PITTIENG) makes use of debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Pitti Engineering

How Much Debt Does Pitti Engineering Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Pitti Engineering had debt of ₹2.63b, up from ₹1.97b in one year. On the flip side, it has ₹131.1m in cash leading to net debt of about ₹2.50b.

How Strong Is Pitti Engineering's Balance Sheet?

The latest balance sheet data shows that Pitti Engineering had liabilities of ₹3.46b due within a year, and liabilities of ₹1.08b falling due after that. On the other hand, it had cash of ₹131.1m and ₹1.54b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.87b.

This deficit casts a shadow over the ₹1.60b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Pitti Engineering would likely require a major re-capitalisation if it had to pay its creditors today.

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

While Pitti Engineering's debt to EBITDA ratio (4.1) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Pitti Engineering saw its EBIT tank 42% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Pitti Engineering 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Pitti Engineering basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

On the face of it, Pitti Engineering's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its conversion of EBIT to free cash flow fails to inspire much confidence. We think the chances that Pitti Engineering has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Pitti Engineering (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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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