Here's Why Precot (NSE:PRECOT) Is Weighed Down By Its Debt Load

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Precot Limited (NSE:PRECOT) makes use of debt. But is this debt a concern to shareholders?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. 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

What Is Precot's Debt?

As you can see below, Precot had ₹3.39b of debt at September 2023, down from ₹4.12b a year prior. On the flip side, it has ₹103.7m in cash leading to net debt of about ₹3.28b.

How Healthy Is Precot's Balance Sheet?

According to the last reported balance sheet, Precot had liabilities of ₹2.90b due within 12 months, and liabilities of ₹1.57b due beyond 12 months. Offsetting these obligations, it had cash of ₹103.7m as well as receivables valued at ₹1.12b due within 12 months. So its liabilities total ₹3.24b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of ₹3.60b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.59 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Precot like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Precot saw its EBIT tank 49% over the last 12 months. 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Precot 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Precot's free cash flow amounted to 42% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Precot's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider Precot to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 Precot has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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. 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.