Does Suryalakshmi Cotton Mills (NSE:SURYALAXMI) Have A Healthy Balance Sheet?

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.' 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 Suryalakshmi Cotton Mills Limited (NSE:SURYALAXMI) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Suryalakshmi Cotton Mills

What Is Suryalakshmi Cotton Mills's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Suryalakshmi Cotton Mills had ₹2.66b of debt in March 2021, down from ₹3.16b, one year before. However, because it has a cash reserve of ₹765.3m, its net debt is less, at about ₹1.90b.

A Look At Suryalakshmi Cotton Mills' Liabilities

We can see from the most recent balance sheet that Suryalakshmi Cotton Mills had liabilities of ₹3.27b falling due within a year, and liabilities of ₹1.29b due beyond that. On the other hand, it had cash of ₹765.3m and ₹1.30b worth of receivables due within a year. So its liabilities total ₹2.49b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₹942.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Suryalakshmi Cotton Mills would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Suryalakshmi Cotton Mills shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 0.40 times the interest expense. The debt burden here is substantial. The silver lining is that Suryalakshmi Cotton Mills grew its EBIT by 114% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Suryalakshmi Cotton Mills 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Suryalakshmi Cotton Mills actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We feel some trepidation about Suryalakshmi Cotton Mills's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Suryalakshmi Cotton Mills's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 Suryalakshmi Cotton Mills is showing 4 warning signs in our investment analysis , and 2 of those make us uncomfortable...

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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