Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Shakti Pumps (India) Limited (NSE:SHAKTIPUMP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Shakti Pumps (India)'s Debt?
You can click the graphic below for the historical numbers, but it shows that Shakti Pumps (India) had ₹1.58b of debt in September 2020, down from ₹1.79b, one year before. On the flip side, it has ₹382.5m in cash leading to net debt of about ₹1.20b.
How Healthy Is Shakti Pumps (India)'s Balance Sheet?
We can see from the most recent balance sheet that Shakti Pumps (India) had liabilities of ₹2.64b falling due within a year, and liabilities of ₹353.0m due beyond that. Offsetting these obligations, it had cash of ₹382.5m as well as receivables valued at ₹2.01b due within 12 months. So its liabilities total ₹595.7m more than the combination of its cash and short-term receivables.
Since publicly traded Shakti Pumps (India) shares are worth a total of ₹6.43b, 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 we wouldn't worry about Shakti Pumps (India)'s net debt to EBITDA ratio of 2.9, we think its super-low interest cover of 1.6 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Shakti Pumps (India)'s EBIT was down 57% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Shakti Pumps (India)'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Shakti Pumps (India) basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
On the face of it, Shakti Pumps (India)'s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Looking at the bigger picture, it seems clear to us that Shakti Pumps (India)'s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 6 warning signs for Shakti Pumps (India) you should be aware of, and 2 of them are concerning.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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