Here's Why Butterfly Gandhimathi Appliances (NSE:BUTTERFLY) Is Weighed Down By Its Debt Load

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 Butterfly Gandhimathi Appliances Limited (NSE:BUTTERFLY) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Butterfly Gandhimathi Appliances

What Is Butterfly Gandhimathi Appliances's Debt?

As you can see below, at the end of March 2020, Butterfly Gandhimathi Appliances had ₹1.70b of debt, up from ₹1.54b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

A Look At Butterfly Gandhimathi Appliances's Liabilities

We can see from the most recent balance sheet that Butterfly Gandhimathi Appliances had liabilities of ₹2.64b falling due within a year, and liabilities of ₹357.0m due beyond that. On the other hand, it had cash of ₹8.02m and ₹1.21b worth of receivables due within a year. So its liabilities total ₹1.8b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₹2.29b, so it does suggest shareholders should keep an eye on Butterfly Gandhimathi Appliances's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Butterfly Gandhimathi Appliances shareholders face the double whammy of a high net debt to EBITDA ratio (6.9), and fairly weak interest coverage, since EBIT is just 0.55 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Butterfly Gandhimathi Appliances's EBIT was down 69% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Butterfly Gandhimathi Appliances'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Butterfly Gandhimathi Appliances's free cash flow amounted to 30% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Butterfly Gandhimathi Appliances's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its level of total liabilities also fails to instill confidence. We're quite clear that we consider Butterfly Gandhimathi Appliances to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Butterfly Gandhimathi Appliances (1 is significant) you should be aware of.

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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