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.' 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 Voltas Limited (NSE:VOLTAS) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Voltas's Debt?
As you can see below, at the end of September 2020, Voltas had ₹4.21b of debt, up from ₹3.30b a year ago. Click the image for more detail. However, its balance sheet shows it holds ₹6.07b in cash, so it actually has ₹1.86b net cash.
How Strong Is Voltas's Balance Sheet?
According to the last reported balance sheet, Voltas had liabilities of ₹29.3b due within 12 months, and liabilities of ₹1.27b due beyond 12 months. Offsetting these obligations, it had cash of ₹6.07b as well as receivables valued at ₹24.7b due within 12 months. So these liquid assets roughly match the total liabilities.
This state of affairs indicates that Voltas's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹254.9b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Voltas has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Voltas if management cannot prevent a repeat of the 35% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Voltas 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. Voltas may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Voltas created free cash flow amounting to 8.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While it is always sensible to investigate a company's debt, in this case Voltas has ₹1.86b in net cash and a decent-looking balance sheet. So we don't have any problem with Voltas's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Voltas, you may well want to click here to check an interactive graph of its earnings per share history.
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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