Here's Why Iris Clothings (NSE:IRISDOREME) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Iris Clothings Limited (NSE:IRISDOREME) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Iris Clothings

What Is Iris Clothings's Net Debt?

As you can see below, Iris Clothings had ₹208.2m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₹13.9m, its net debt is less, at about ₹194.3m.

How Strong Is Iris Clothings' Balance Sheet?

According to the last reported balance sheet, Iris Clothings had liabilities of ₹391.5m due within 12 months, and liabilities of ₹69.5m due beyond 12 months. Offsetting these obligations, it had cash of ₹13.9m as well as receivables valued at ₹238.5m due within 12 months. So it has liabilities totalling ₹208.7m more than its cash and near-term receivables, combined.

Since publicly traded Iris Clothings shares are worth a total of ₹3.65b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

While Iris Clothings's low debt to EBITDA ratio of 0.96 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.9 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Even more impressive was the fact that Iris Clothings grew its EBIT by 107% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Iris Clothings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Iris Clothings recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Happily, Iris Clothings's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Iris Clothings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For instance, we've identified 3 warning signs for Iris Clothings that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

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