Is Precot Meridian (NSE:PRECOT) Using Too Much Debt?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Precot Meridian Limited (NSE:PRECOT) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Precot Meridian

How Much Debt Does Precot Meridian Carry?

You can click the graphic below for the historical numbers, but it shows that Precot Meridian had ₹2.48b of debt in September 2020, down from ₹2.91b, one year before. However, because it has a cash reserve of ₹81.7m, its net debt is less, at about ₹2.40b.

How Healthy Is Precot Meridian's Balance Sheet?

According to the last reported balance sheet, Precot Meridian had liabilities of ₹2.47b due within 12 months, and liabilities of ₹1.33b due beyond 12 months. On the other hand, it had cash of ₹81.7m and ₹930.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.79b.

This deficit casts a shadow over the ₹678.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Precot Meridian would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Precot Meridian's debt to EBITDA ratio (3.5) suggests that it uses some debt, its interest cover is very weak, at 0.73, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Precot Meridian boosted its EBIT by a silky 88% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Precot Meridian 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Precot Meridian actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While Precot Meridian's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Precot Meridian is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 2 warning signs we've spotted with Precot Meridian (including 1 which is makes us a bit uncomfortable) .

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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This article by Simply Wall St is general in nature. 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.
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