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.' 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. Importantly, Century Enka Limited (NSE:CENTENKA) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Century Enka's Debt?
As you can see below, Century Enka had ₹131.5m of debt at March 2021, down from ₹226.3m a year prior. But on the other hand it also has ₹3.48b in cash, leading to a ₹3.35b net cash position.
How Healthy Is Century Enka's Balance Sheet?
The latest balance sheet data shows that Century Enka had liabilities of ₹1.46b due within a year, and liabilities of ₹1.04b falling due after that. Offsetting these obligations, it had cash of ₹3.48b as well as receivables valued at ₹2.58b due within 12 months. So it actually has ₹3.56b more liquid assets than total liabilities.
This surplus liquidity suggests that Century Enka's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Century Enka has more cash than debt is arguably a good indication that it can manage its debt safely.
Although Century Enka made a loss at the EBIT level, last year, it was also good to see that it generated ₹1.7b in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Century Enka's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Century Enka may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent year, Century Enka recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Century Enka has ₹3.35b in net cash and a decent-looking balance sheet. So we don't think Century Enka's use of debt is risky. 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. To that end, you should learn about the 2 warning signs we've spotted with Century Enka (including 1 which is concerning) .
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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