Is Somany Home Innovation (NSE:SHIL) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Somany Home Innovation Limited (NSE:SHIL) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for Somany Home Innovation

What Is Somany Home Innovation's Net Debt?

As you can see below, Somany Home Innovation had ₹1.03b of debt at March 2021, down from ₹3.28b a year prior. However, it also had ₹332.5m in cash, and so its net debt is ₹698.2m.

How Strong Is Somany Home Innovation's Balance Sheet?

The latest balance sheet data shows that Somany Home Innovation had liabilities of ₹5.80b due within a year, and liabilities of ₹1.28b falling due after that. On the other hand, it had cash of ₹332.5m and ₹4.08b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.67b.

Given Somany Home Innovation has a market capitalization of ₹23.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 Somany Home Innovation's low debt to EBITDA ratio of 0.43 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Somany Home Innovation's EBIT shot up like bamboo after rain, gaining 77% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Somany Home Innovation'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Somany Home Innovation recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Somany Home Innovation's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its interest cover. Looking at the bigger picture, we think Somany Home Innovation's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return 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. For instance, we've identified 2 warning signs for Somany Home Innovation that you should be aware of.

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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This article by Simply Wall St is general in nature. 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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