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.' 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. Importantly, Shakti Pumps (India) Limited (NSE:SHAKTIPUMP) does carry debt. But the more important question is: how much risk is that debt creating?
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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Shakti Pumps (India)'s Net Debt?
The image below, which you can click on for greater detail, shows that Shakti Pumps (India) had debt of ₹1.16b at the end of September 2021, a reduction from ₹1.58b over a year. However, because it has a cash reserve of ₹318.6m, its net debt is less, at about ₹843.7m.
A Look At Shakti Pumps (India)'s Liabilities
According to the last reported balance sheet, Shakti Pumps (India) had liabilities of ₹4.32b due within 12 months, and liabilities of ₹289.9m due beyond 12 months. Offsetting these obligations, it had cash of ₹318.6m as well as receivables valued at ₹3.60b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹694.3m.
Since publicly traded Shakti Pumps (India) shares are worth a total of ₹10.5b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Shakti Pumps (India) has a low net debt to EBITDA ratio of only 0.57. And its EBIT easily covers its interest expense, being 16.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Shakti Pumps (India) grew its EBIT by 447% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shakti Pumps (India) 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Shakti Pumps (India) recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Shakti Pumps (India)'s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Zooming out, Shakti Pumps (India) seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. To that end, you should be aware of the 2 warning signs we've spotted with Shakti Pumps (India) .
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.
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.
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