Sutlej Textiles and Industries (NSE:SUTLEJTEX) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Sutlej Textiles and Industries Limited (NSE:SUTLEJTEX) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sutlej Textiles and Industries

What Is Sutlej Textiles and Industries's Net Debt?

As you can see below, at the end of September 2021, Sutlej Textiles and Industries had ₹8.41b of debt, up from ₹6.80b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹196.1m, its net debt is less, at about ₹8.22b.

How Strong Is Sutlej Textiles and Industries' Balance Sheet?

The latest balance sheet data shows that Sutlej Textiles and Industries had liabilities of ₹7.28b due within a year, and liabilities of ₹4.56b falling due after that. Offsetting these obligations, it had cash of ₹196.1m as well as receivables valued at ₹3.58b due within 12 months. So it has liabilities totalling ₹8.07b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹12.3b, so it does suggest shareholders should keep an eye on Sutlej Textiles and Industries' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sutlej Textiles and Industries's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 5.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We also note that Sutlej Textiles and Industries improved its EBIT from a last year's loss to a positive ₹1.7b. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sutlej Textiles and Industries's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, Sutlej Textiles and Industries actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over Sutlej Textiles and Industries's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its interest cover is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sutlej Textiles and Industries stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Sutlej Textiles and Industries (of which 2 shouldn't be ignored!) 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.