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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Superhouse Limited (NSE:SUPERHOUSE) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Superhouse
What Is Superhouse's Debt?
As you can see below, Superhouse had ₹1.93b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₹768.4m in cash, and so its net debt is ₹1.17b.
How Strong Is Superhouse's Balance Sheet?
We can see from the most recent balance sheet that Superhouse had liabilities of ₹3.35b falling due within a year, and liabilities of ₹424.6m due beyond that. Offsetting these obligations, it had cash of ₹768.4m as well as receivables valued at ₹1.91b due within 12 months. So it has liabilities totalling ₹1.09b more than its cash and near-term receivables, combined.
Superhouse has a market capitalization of ₹2.83b, so it could very likely raise cash to ameliorate 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Superhouse's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 4.6 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw Superhouse grow its EBIT by 9.0% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is Superhouse's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Superhouse created free cash flow amounting to 2.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
Superhouse's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. Taking the abovementioned factors together we do think Superhouse's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Superhouse is showing 3 warning signs in our investment analysis , you should know about...
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.
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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:SUPERHOUSE
Superhouse
Engages in the manufacture and sale of leather and leather products, and textile garments in India and internationally.
Adequate balance sheet slight.