These 4 Measures Indicate That Ambika Cotton Mills (NSE:AMBIKCO) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Ambika Cotton Mills Limited (NSE:AMBIKCO) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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

See 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.

A Look At Ambika Cotton Mills' Liabilities

Zooming in on the latest balance sheet data, we can see that Ambika Cotton Mills had liabilities of ₹1.30b due within 12 months and liabilities of ₹270.5m due beyond that. On the other hand, it had cash of ₹27.2m and ₹436.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.10b.

Given Ambika Cotton Mills has a market capitalization of ₹5.63b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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 0.45. And its EBIT easily covers its interest expense, being 11.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Ambika Cotton Mills has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Ambika Cotton Mills 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 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. During the last three years, Ambika Cotton Mills burned a lot of cash. 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 cast it in a significantly better light. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Ambika Cotton Mills's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Ambika Cotton Mills (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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