Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Parin Furniture Limited (NSE:PARIN) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Parin Furniture Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Parin Furniture had debt of ₹386.1m, up from ₹305.2m in one year. On the flip side, it has ₹49.5m in cash leading to net debt of about ₹336.6m.
A Look At Parin Furniture's Liabilities
Zooming in on the latest balance sheet data, we can see that Parin Furniture had liabilities of ₹403.7m due within 12 months and liabilities of ₹156.3m due beyond that. Offsetting these obligations, it had cash of ₹49.5m as well as receivables valued at ₹449.6m due within 12 months. So it has liabilities totalling ₹60.9m more than its cash and near-term receivables, combined.
Of course, Parin Furniture has a market capitalization of ₹667.1m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Parin Furniture has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Parin Furniture grew its EBIT by 25% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Parin Furniture will need earnings to service that debt. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Parin Furniture 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.
Parin Furniture's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. We think that Parin Furniture's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Parin Furniture .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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