Here's Why Kanani Industries (NSE:KANANIIND) Can Manage Its Debt Responsibly

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 note that Kanani Industries Limited (NSE:KANANIIND) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Kanani Industries

What Is Kanani Industries's Debt?

As you can see below, at the end of March 2022, Kanani Industries had ₹244.8m of debt, up from ₹221.8m a year ago. Click the image for more detail. However, because it has a cash reserve of ₹45.8m, its net debt is less, at about ₹199.0m.

How Strong Is Kanani Industries' Balance Sheet?

We can see from the most recent balance sheet that Kanani Industries had liabilities of ₹816.1m falling due within a year, and liabilities of ₹5.90m due beyond that. Offsetting this, it had ₹45.8m in cash and ₹1.02b in receivables that were due within 12 months. So it can boast ₹247.7m more liquid assets than total liabilities.

It's good to see that Kanani Industries has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

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.

Kanani Industries shareholders face the double whammy of a high net debt to EBITDA ratio (11.6), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. This means we'd consider it to have a heavy debt load. The silver lining is that Kanani Industries grew its EBIT by 111% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kanani 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. Over the last three years, Kanani Industries actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Kanani Industries's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its net debt to EBITDA has the opposite effect. Zooming out, Kanani Industries seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Kanani Industries , and understanding them should be part of your investment process.

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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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.