We Think PNC Infratech (NSE:PNCINFRA) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that PNC Infratech Limited (NSE:PNCINFRA) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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 PNC Infratech

What Is PNC Infratech's Debt?

As you can see below, at the end of March 2021, PNC Infratech had ₹37.5b of debt, up from ₹35.2b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹15.4b, its net debt is less, at about ₹22.1b.

How Healthy Is PNC Infratech's Balance Sheet?

According to the last reported balance sheet, PNC Infratech had liabilities of ₹16.4b due within 12 months, and liabilities of ₹48.9b due beyond 12 months. On the other hand, it had cash of ₹15.4b and ₹6.73b worth of receivables due within a year. So its liabilities total ₹43.1b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since PNC Infratech has a market capitalization of ₹82.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While PNC Infratech has a quite reasonable net debt to EBITDA multiple of 1.6, its interest cover seems weak, at 2.5. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. PNC Infratech grew its EBIT by 7.8% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 PNC Infratech 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, PNC Infratech reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both PNC Infratech's interest cover and its conversion of EBIT to free cash flow were discouraging. At least its EBIT growth rate gives us reason to be optimistic. Taking the abovementioned factors together we do think PNC Infratech's debt poses some risks to the business. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for PNC Infratech (1 shouldn't be ignored) you should be aware of.

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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