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.' 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. We note that S.P. Apparels Limited (NSE:SPAL) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for S.P. Apparels
What Is S.P. Apparels's Net Debt?
As you can see below, S.P. Apparels had ₹2.15b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have ₹969.2m in cash offsetting this, leading to net debt of about ₹1.18b.
How Healthy Is S.P. Apparels' Balance Sheet?
We can see from the most recent balance sheet that S.P. Apparels had liabilities of ₹3.07b falling due within a year, and liabilities of ₹1.07b due beyond that. Offsetting these obligations, it had cash of ₹969.2m as well as receivables valued at ₹1.36b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.81b.
This deficit isn't so bad because S.P. Apparels is worth ₹8.55b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 0.81 times EBITDA, S.P. Apparels is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.5 times the interest expense over the last year. And we also note warmly that S.P. Apparels grew its EBIT by 13% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if S.P. Apparels can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, S.P. Apparels's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
The good news is that S.P. Apparels's demonstrated ability handle its debt, based on its EBITDA, delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. Looking at all the aforementioned factors together, it strikes us that S.P. Apparels can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Over time, share prices tend to follow earnings per share, so if you're interested in S.P. Apparels, you may well want to click here to check an interactive graph of its earnings per share history.
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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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.
About NSEI:SPAL
S.P. Apparels
Engages in manufacturing and exporting of knitted garments for infants and children in India and internationally.
Flawless balance sheet and undervalued.