Celebrity Fashions (NSE:CELEBRITY) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Celebrity Fashions Limited (NSE:CELEBRITY) does use debt in its business. But is this debt a concern to shareholders?

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. 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 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 Celebrity Fashions

How Much Debt Does Celebrity Fashions Carry?

As you can see below, Celebrity Fashions had ₹685.9m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₹35.0m in cash, and so its net debt is ₹650.9m.

A Look At Celebrity Fashions' Liabilities

We can see from the most recent balance sheet that Celebrity Fashions had liabilities of ₹1.03b falling due within a year, and liabilities of ₹418.5m due beyond that. Offsetting this, it had ₹35.0m in cash and ₹442.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹972.0m.

This deficit casts a shadow over the ₹513.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Celebrity Fashions would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Celebrity Fashions's debt to EBITDA ratio (4.8) suggests that it uses some debt, its interest cover is very weak, at 2.5, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Celebrity Fashions actually grew its EBIT by a hefty 418%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But it is Celebrity Fashions'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Celebrity Fashions actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While Celebrity Fashions's level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Celebrity Fashions's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 2 warning signs with Celebrity Fashions , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.