These 4 Measures Indicate That Sonam (NSE:SONAMLTD) Is Using Debt Reasonably Well

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Sonam Limited (NSE:SONAMLTD) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Sonam

How Much Debt Does Sonam Carry?

The image below, which you can click on for greater detail, shows that Sonam had debt of ₹232.7m at the end of September 2023, a reduction from ₹282.4m over a year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Sonam's Balance Sheet?

According to the last reported balance sheet, Sonam had liabilities of ₹243.4m due within 12 months, and liabilities of ₹87.3m due beyond 12 months. On the other hand, it had cash of ₹908.0k and ₹148.4m worth of receivables due within a year. So its liabilities total ₹181.4m more than the combination of its cash and short-term receivables.

Of course, Sonam has a market capitalization of ₹1.73b, 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sonam's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 2.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. If Sonam can keep growing EBIT at last year's rate of 20% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sonam will need earnings to service that debt. 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 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. In the last three years, Sonam's free cash flow amounted to 37% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Sonam was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For example, its interest cover makes us a little nervous about its debt. Considering this range of data points, we think Sonam is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Sonam is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.