Is Revathi Equipment (NSE:REVATHI) A Risky Investment?

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.' 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, Revathi Equipment Limited (NSE:REVATHI) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Revathi Equipment

How Much Debt Does Revathi Equipment Carry?

The image below, which you can click on for greater detail, shows that at September 2021 Revathi Equipment had debt of ₹506.4m, up from ₹202.3m in one year. On the flip side, it has ₹427.0m in cash leading to net debt of about ₹79.4m.

How Healthy Is Revathi Equipment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Revathi Equipment had liabilities of ₹1.10b due within 12 months and liabilities of ₹73.6m due beyond that. Offsetting these obligations, it had cash of ₹427.0m as well as receivables valued at ₹782.2m due within 12 months. So it can boast ₹40.3m more liquid assets than total liabilities.

This state of affairs indicates that Revathi Equipment's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the ₹2.16b company is short on cash, but still worth keeping an eye on the balance sheet.

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.

Revathi Equipment's net debt is only 0.70 times its EBITDA. And its EBIT easily covers its interest expense, being 19.1 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Revathi Equipment's load is not too heavy, because its EBIT was down 24% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is Revathi Equipment's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Revathi Equipment reported free cash flow worth 3.7% 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

Neither Revathi Equipment's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Revathi Equipment's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 2 warning signs for Revathi Equipment that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.