We Think Kanani Industries (NSE:KANANIIND) Is Taking Some Risk With Its 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Kanani Industries Limited (NSE:KANANIIND) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kanani Industries

How Much Debt Does Kanani Industries Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Kanani Industries had debt of ₹302.6m, up from ₹214.5m in one year. However, it also had ₹50.5m in cash, and so its net debt is ₹252.1m.

A Look At Kanani Industries' Liabilities

We can see from the most recent balance sheet that Kanani Industries had liabilities of ₹592.6m falling due within a year, and liabilities of ₹62.6m due beyond that. On the other hand, it had cash of ₹50.5m and ₹961.9m worth of receivables due within a year. So it can boast ₹357.2m more liquid assets than total liabilities.

This surplus liquidity suggests that Kanani Industries' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 1.6 times and a disturbingly high net debt to EBITDA ratio of 16.4 hit our confidence in Kanani Industries like a one-two punch to the gut. The debt burden here is substantial. Worse, Kanani Industries's EBIT was down 47% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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

Kanani Industries's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to handle its total liabilities with ease. Taking the abovementioned factors together we do think Kanani Industries's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Kanani Industries .

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.

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