Does Salona Cotspin (NSE:SALONA) Have A Healthy Balance Sheet?

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.' 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. Importantly, Salona Cotspin Limited (NSE:SALONA) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Salona Cotspin

How Much Debt Does Salona Cotspin Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Salona Cotspin had ₹390.1m of debt, an increase on ₹334.8m, over one year. However, it also had ₹66.9m in cash, and so its net debt is ₹323.2m.

A Look At Salona Cotspin's Liabilities

Zooming in on the latest balance sheet data, we can see that Salona Cotspin had liabilities of ₹406.3m due within 12 months and liabilities of ₹128.5m due beyond that. On the other hand, it had cash of ₹66.9m and ₹276.0m worth of receivables due within a year. So its liabilities total ₹191.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Salona Cotspin has a market capitalization of ₹338.4m, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Salona Cotspin's net debt to EBITDA ratio of 4.0, we think its super-low interest cover of 1.9 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Salona Cotspin improved its EBIT by 5.5% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Salona Cotspin's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Salona Cotspin 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.

Our View

To be frank both Salona Cotspin's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Salona Cotspin's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Salona Cotspin is showing 4 warning signs in our investment analysis , and 3 of those are a bit concerning...

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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