Tarmat (NSE:TARMAT) Has A Somewhat Strained Balance Sheet

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.' 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. We note that Tarmat Limited (NSE:TARMAT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Tarmat

What Is Tarmat's Debt?

As you can see below, Tarmat had ₹894.7m of debt at March 2021, down from ₹1.10b a year prior. However, it does have ₹147.0m in cash offsetting this, leading to net debt of about ₹747.7m.

How Healthy Is Tarmat's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tarmat had liabilities of ₹802.7m due within 12 months and liabilities of ₹909.9m due beyond that. On the other hand, it had cash of ₹147.0m and ₹907.9m worth of receivables due within a year. So it has liabilities totalling ₹657.7m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹1.04b, so it does suggest shareholders should keep an eye on Tarmat's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 10.5 hit our confidence in Tarmat like a one-two punch to the gut. The debt burden here is substantial. Even worse, Tarmat saw its EBIT tank 44% over the last 12 months. 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 Tarmat'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent two years, Tarmat recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Tarmat's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its level of total liabilities also fails to instill confidence. We're quite clear that we consider Tarmat to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Tarmat (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.

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