Linc Pen & Plastics (NSE:LINCPEN) Takes On Some Risk With Its Use Of Debt

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.' 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 Linc Pen & Plastics Limited (NSE:LINCPEN) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Linc Pen & Plastics

How Much Debt Does Linc Pen & Plastics Carry?

As you can see below, Linc Pen & Plastics had ₹436.5m of debt at September 2020, down from ₹549.2m a year prior. However, it also had ₹23.6m in cash, and so its net debt is ₹412.8m.

How Healthy Is Linc Pen & Plastics's Balance Sheet?

We can see from the most recent balance sheet that Linc Pen & Plastics had liabilities of ₹696.6m falling due within a year, and liabilities of ₹209.6m due beyond that. Offsetting this, it had ₹23.6m in cash and ₹360.7m in receivables that were due within 12 months. So its liabilities total ₹521.9m more than the combination of its cash and short-term receivables.

Of course, Linc Pen & Plastics has a market capitalization of ₹2.75b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Linc Pen & Plastics has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 2.4. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, Linc Pen & Plastics's EBIT fell a jaw-dropping 51% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Linc Pen & Plastics'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Linc Pen & Plastics actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither Linc Pen & Plastics's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Linc Pen & Plastics is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 example, we've discovered 4 warning signs for Linc Pen & Plastics (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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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