Kanani Industries (NSE:KANANIIND) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Kanani Industries Limited (NSE:KANANIIND) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kanani Industries

What Is Kanani Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Kanani Industries had ₹302.6m of debt, an increase on ₹214.5m, over one year. However, it also had ₹50.5m in cash, and so its net debt is ₹252.1m.

How Healthy Is Kanani Industries's Balance Sheet?

The latest balance sheet data shows that Kanani Industries had liabilities of ₹592.6m due within a year, and liabilities of ₹62.6m falling due after that. On the other hand, it had cash of ₹50.5m and ₹960.9m worth of receivables due within a year. So it can boast ₹356.1m more liquid assets than total liabilities.

This excess liquidity is a great indication that Kanani Industries's balance sheet is just as strong as racists are weak. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Kanani Industries shareholders face the double whammy of a high net debt to EBITDA ratio (10.2), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. This means we'd consider it to have a heavy debt load. More concerning, Kanani Industries saw its EBIT drop by 6.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Kanani Industries'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kanani Industries saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Kanani Industries's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its level of total liabilities tells a very different story, and suggests some resilience. We think that Kanani Industries's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Kanani Industries is showing 3 warning signs in our investment analysis , and 2 of those can't be ignored...

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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