David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Nandan Denim Limited (NSE:NDL) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
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What Is Nandan Denim's Net Debt?
As you can see below, Nandan Denim had ₹4.65b of debt at March 2023, down from ₹5.58b a year prior. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Nandan Denim's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Nandan Denim had liabilities of ₹5.44b due within 12 months and liabilities of ₹1.83b due beyond that. On the other hand, it had cash of ₹31.7m and ₹4.58b worth of receivables due within a year. So its liabilities total ₹2.65b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₹3.34b, so it does suggest shareholders should keep an eye on Nandan Denim's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Weak interest cover of 0.77 times and a disturbingly high net debt to EBITDA ratio of 6.4 hit our confidence in Nandan Denim like a one-two punch to the gut. The debt burden here is substantial. Worse, Nandan Denim's EBIT was down 73% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Nandan Denim'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Nandan Denim actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
To be frank both Nandan Denim's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Nandan Denim has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example Nandan Denim has 2 warning signs (and 1 which is potentially serious) we think you should know about.
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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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.
About NSEI:NDL
Nandan Denim
Engages in the manufacture and sale of denim and cotton fabrics, dyed yarns, shirting fabrics, and fibers in India.
Moderate with adequate balance sheet.