Ambika Cotton Mills (NSE:AMBIKCO) Seems To Use Debt Quite Sensibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Ambika Cotton Mills Limited (NSE:AMBIKCO) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 our latest analysis for Ambika Cotton Mills

How Much Debt Does Ambika Cotton Mills Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Ambika Cotton Mills had debt of ₹480.7m, up from ₹191.4m in one year. However, it does have ₹27.2m in cash offsetting this, leading to net debt of about ₹453.5m.

How Healthy Is Ambika Cotton Mills's Balance Sheet?

According to the last reported balance sheet, Ambika Cotton Mills had liabilities of ₹1.30b due within 12 months, and liabilities of ₹270.5m due beyond 12 months. Offsetting this, it had ₹27.2m in cash and ₹436.5m in receivables that were due within 12 months. So its liabilities total ₹1.10b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Ambika Cotton Mills is worth ₹4.12b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Ambika Cotton Mills has a low net debt to EBITDA ratio of only 0.47. And its EBIT easily covers its interest expense, being 10.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Ambika Cotton Mills grew its EBIT by 377% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Ambika Cotton Mills'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ambika Cotton Mills saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Ambika Cotton Mills's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. Considering this range of data points, we think Ambika Cotton Mills is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Ambika Cotton Mills (1 is a bit unpleasant) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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.
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