These 4 Measures Indicate That Salona Cotspin (NSE:SALONA) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. 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?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Salona Cotspin

What Is Salona Cotspin's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Salona Cotspin had debt of ₹2.24b, up from ₹1.91b in one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Salona Cotspin's Balance Sheet?

The latest balance sheet data shows that Salona Cotspin had liabilities of ₹1.73b due within a year, and liabilities of ₹835.8m falling due after that. Offsetting these obligations, it had cash of ₹24.1m as well as receivables valued at ₹1.41b due within 12 months. So its liabilities total ₹1.14b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of ₹1.32b, so it does suggest shareholders should keep an eye on Salona Cotspin's use of debt. 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.

Salona Cotspin shareholders face the double whammy of a high net debt to EBITDA ratio (6.8), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that Salona Cotspin improved its EBIT by 7.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. 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.

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 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 net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Salona Cotspin to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Salona Cotspin (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.

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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.