Donear Industries (NSE:DONEAR) Has A Somewhat Strained Balance Sheet

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 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 note that Donear Industries Limited (NSE:DONEAR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Donear Industries

What Is Donear Industries's Net Debt?

The image below, which you can click on for greater detail, shows that Donear Industries had debt of ₹2.36b at the end of September 2020, a reduction from ₹3.20b over a year. However, it does have ₹174.3m in cash offsetting this, leading to net debt of about ₹2.19b.

How Strong Is Donear Industries's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Donear Industries had liabilities of ₹3.30b due within 12 months and liabilities of ₹202.2m due beyond that. Offsetting these obligations, it had cash of ₹174.3m as well as receivables valued at ₹899.8m due within 12 months. So its liabilities total ₹2.43b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of ₹1.78b, we think shareholders really should watch Donear Industries's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.96 times and a disturbingly high net debt to EBITDA ratio of 8.5 hit our confidence in Donear Industries like a one-two punch to the gut. The debt burden here is substantial. Even worse, Donear Industries saw its EBIT tank 65% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Donear Industries will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Happily for any shareholders, Donear Industries actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Donear Industries's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Donear Industries's balance sheet is really quite a risk to the business. 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Donear Industries you should be aware of, and 1 of them is potentially serious.

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. 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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