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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Nahar Spinning Mills Ltd (NSE:NAHARSPING) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is Nahar Spinning Mills's Net Debt?
As you can see below, at the end of March 2021, Nahar Spinning Mills had ₹10.7b of debt, up from ₹9.24b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Nahar Spinning Mills' Balance Sheet?
We can see from the most recent balance sheet that Nahar Spinning Mills had liabilities of ₹10.9b falling due within a year, and liabilities of ₹2.14b due beyond that. Offsetting this, it had ₹17.6m in cash and ₹3.33b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹9.69b.
When you consider that this deficiency exceeds the company's ₹7.12b market capitalization, you might well be inclined to review the balance sheet intently. 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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.5 hit our confidence in Nahar Spinning Mills like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that Nahar Spinning Mills achieved a positive EBIT of ₹1.1b in the last twelve months, an improvement on the prior year's loss. 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 Nahar Spinning Mills 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Nahar Spinning Mills saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both Nahar Spinning Mills's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Nahar Spinning Mills has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Nahar Spinning Mills has 5 warning signs (and 2 which don't sit too well with us) we think you should know about.
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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