Does Somany Ceramics (NSE:SOMANYCERA) Have A Healthy Balance Sheet?

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.' 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 note that Somany Ceramics Limited (NSE:SOMANYCERA) does have debt on its balance sheet. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Somany Ceramics

How Much Debt Does Somany Ceramics Carry?

The image below, which you can click on for greater detail, shows that Somany Ceramics had debt of ₹3.93b at the end of September 2020, a reduction from ₹5.70b over a year. However, it does have ₹1.37b in cash offsetting this, leading to net debt of about ₹2.56b.

A Look At Somany Ceramics's Liabilities

The latest balance sheet data shows that Somany Ceramics had liabilities of ₹4.81b due within a year, and liabilities of ₹2.84b falling due after that. Offsetting these obligations, it had cash of ₹1.37b as well as receivables valued at ₹2.52b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹3.75b.

This deficit isn't so bad because Somany Ceramics is worth ₹13.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Somany Ceramics's debt to EBITDA ratio (3.0) suggests that it uses some debt, its interest cover is very weak, at 1.2, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Somany Ceramics saw its EBIT tank 73% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Somany Ceramics can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. During the last three years, Somany Ceramics produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Somany Ceramics'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 converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Somany Ceramics stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Somany Ceramics is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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