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.’ 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. We can see that Salona Cotspin Limited (NSE:SALONACOT) does use debt in its business. But should shareholders be worried about its use of debt?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Salona Cotspin’s Net Debt?
As you can see below, at the end of March 2019, Salona Cotspin had ₹477.8m of debt, up from ₹433.4m a year ago. Click the image for more detail. However, it does have ₹17.2m in cash offsetting this, leading to net debt of about ₹460.6m.
How Strong Is Salona Cotspin’s Balance Sheet?
According to the last reported balance sheet, Salona Cotspin had liabilities of ₹485.3m due within 12 months, and liabilities of ₹100.5m due beyond 12 months. Offsetting this, it had ₹17.2m in cash and ₹228.8m in receivables that were due within 12 months. So its liabilities total ₹339.7m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of ₹390.6m. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Salona Cotspin does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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 blink an eye at Salona Cotspin’s net debt to EBITDA ratio of 4.65, we think its super-low interest cover of 1.55 times is a bad sign. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On a slightly more positive note, Salona Cotspin grew its EBIT at 11% over the last year, further increasing its ability to manage debt. There’s no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Salona Cotspin saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
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. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Salona Cotspin’s debt load is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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