Is Nandan Denim (NSE:NDL) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Nandan Denim Limited (NSE:NDL) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Nandan Denim

What Is Nandan Denim's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Nandan Denim had ₹6.16b of debt, an increase on ₹5.00b, over one year. On the flip side, it has ₹1.42b in cash leading to net debt of about ₹4.74b.

How Healthy Is Nandan Denim's Balance Sheet?

We can see from the most recent balance sheet that Nandan Denim had liabilities of ₹5.66b falling due within a year, and liabilities of ₹2.95b due beyond that. On the other hand, it had cash of ₹1.42b and ₹4.18b worth of receivables due within a year. So its liabilities total ₹3.02b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Nandan Denim has a market capitalization of ₹7.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Nandan Denim's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We also note that Nandan Denim improved its EBIT from a last year's loss to a positive ₹1.4b. 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 Nandan Denim 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 the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Nandan Denim recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Nandan Denim's interest cover and its conversion of EBIT to free cash flow were discouraging. But its not so bad at (not) growing its EBIT. Taking the abovementioned factors together we do think Nandan Denim's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 4 warning signs with Nandan Denim (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

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.