Is Salona Cotspin (NSE:SALONA) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Salona Cotspin Limited (NSE:SALONA) makes use of debt. But the real question is whether this debt is making the company risky.

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Salona Cotspin

What Is Salona Cotspin's Net Debt?

As you can see below, at the end of March 2022, Salona Cotspin had ₹1.39b of debt, up from ₹765.1m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Salona Cotspin's Balance Sheet?

The latest balance sheet data shows that Salona Cotspin had liabilities of ₹1.39b due within a year, and liabilities of ₹314.4m falling due after that. Offsetting this, it had ₹4.02m in cash and ₹962.1m in receivables that were due within 12 months. So it has liabilities totalling ₹741.1m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹1.15b, so it does suggest shareholders should keep an eye on Salona Cotspin's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Salona Cotspin's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 4.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Pleasingly, Salona Cotspin is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 169% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Salona Cotspin 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Salona Cotspin burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Salona Cotspin's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Salona Cotspin's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 instance, we've identified 5 warning signs for Salona Cotspin (2 are potentially serious) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.