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 Sutlej Textiles and Industries Limited (NSE:SUTLEJTEX) does use debt in its business. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Sutlej Textiles and Industries Carry?
You can click the graphic below for the historical numbers, but it shows that Sutlej Textiles and Industries had ₹7.80b of debt in March 2021, down from ₹8.73b, one year before. However, it also had ₹823.6m in cash, and so its net debt is ₹6.97b.
How Strong Is Sutlej Textiles and Industries' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sutlej Textiles and Industries had liabilities of ₹6.73b due within 12 months and liabilities of ₹5.11b due beyond that. Offsetting this, it had ₹823.6m in cash and ₹2.76b in receivables that were due within 12 months. So its liabilities total ₹8.26b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of ₹10.3b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Weak interest cover of 0.23 times and a disturbingly high net debt to EBITDA ratio of 6.7 hit our confidence in Sutlej Textiles and Industries like a one-two punch to the gut. The debt burden here is substantial. Worse, Sutlej Textiles and Industries's EBIT was down 89% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Sutlej Textiles and Industries 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Sutlej Textiles and Industries actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, Sutlej Textiles and Industries's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Sutlej Textiles and Industries's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sutlej Textiles and Industries is showing 4 warning signs in our investment analysis , and 2 of those are a bit concerning...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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