Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that Rupa & Company Limited (NSE:RUPA) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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, 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.
What Is Rupa’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Rupa had debt of ₹2.08b, up from ₹1.16b in one year. However, it also had ₹75.9m in cash, and so its net debt is ₹2.00b.
How Strong Is Rupa’s Balance Sheet?
We can see from the most recent balance sheet that Rupa had liabilities of ₹4.57b falling due within a year, and liabilities of ₹155.3m due beyond that. On the other hand, it had cash of ₹75.9m and ₹3.98b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹663.1m.
Of course, Rupa has a market capitalization of ₹20.5b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Because it carries more debt than cash, we think it’s worth watching Rupa’s balance sheet over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 1.33 times EBITDA, Rupa is arguably pretty conservatively geared. And it boasts interest cover of 7.33 times, which is more than adequate. But the other side of the story is that Rupa saw its EBIT decline by 2.6% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Rupa’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. Over the last three years, Rupa reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Rupa’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better There’s no doubt that it has an adequate capacity to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Rupa’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Rupa’s earnings per share history for free.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.