Is Aarvi Encon (NSE:AARVI) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Aarvi Encon Limited (NSE:AARVI) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out the opportunities and risks within the IN Professional Services industry.

What Is Aarvi Encon's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Aarvi Encon had ₹142.9m of debt, an increase on ₹22.3m, over one year. However, it does have ₹79.7m in cash offsetting this, leading to net debt of about ₹63.1m.

A Look At Aarvi Encon's Liabilities

We can see from the most recent balance sheet that Aarvi Encon had liabilities of ₹592.2m falling due within a year, and liabilities of ₹20.0m due beyond that. Offsetting these obligations, it had cash of ₹79.7m as well as receivables valued at ₹757.8m due within 12 months. So it actually has ₹225.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Aarvi Encon could probably pay off its debt with ease, as its balance sheet is far from stretched.

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

Aarvi Encon's net debt is only 0.37 times its EBITDA. And its EBIT easily covers its interest expense, being 84.3 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Aarvi Encon grew its EBIT by 79% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Aarvi Encon'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.

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 three years, Aarvi Encon recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Aarvi Encon's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think Aarvi Encon's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Aarvi Encon is showing 4 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.