Is Kapston Facilities Management (NSE:KAPSTON) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Kapston Facilities Management Limited (NSE:KAPSTON) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Kapston Facilities Management

What Is Kapston Facilities Management's Debt?

You can click the graphic below for the historical numbers, but it shows that Kapston Facilities Management had ₹372.2m of debt in September 2020, down from ₹491.2m, one year before. However, it also had ₹147.8m in cash, and so its net debt is ₹224.3m.

How Healthy Is Kapston Facilities Management's Balance Sheet?

The latest balance sheet data shows that Kapston Facilities Management had liabilities of ₹497.5m due within a year, and liabilities of ₹129.5m falling due after that. On the other hand, it had cash of ₹147.8m and ₹509.3m worth of receivables due within a year. So it actually has ₹30.1m more liquid assets than total liabilities.

This surplus suggests that Kapston Facilities Management has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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 Kapston Facilities Management's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.2 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. Importantly Kapston Facilities Management's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Kapston Facilities Management will need earnings to service that debt. 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.

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, Kapston Facilities Management burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Kapston Facilities Management's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to handle its total liabilities isn't too shabby at all. We think that Kapston Facilities Management's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 2 warning signs for Kapston Facilities Management 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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