Is United Polyfab Gujarat (NSE:UNITEDPOLY) A Risky Investment?

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. We can see that United Polyfab Gujarat Limited (NSE:UNITEDPOLY) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for United Polyfab Gujarat

What Is United Polyfab Gujarat's Net Debt?

The image below, which you can click on for greater detail, shows that United Polyfab Gujarat had debt of ₹1.17b at the end of September 2020, a reduction from ₹1.27b over a year. On the flip side, it has ₹66.7m in cash leading to net debt of about ₹1.11b.

How Healthy Is United Polyfab Gujarat's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that United Polyfab Gujarat had liabilities of ₹221.9m due within 12 months and liabilities of ₹1.18b due beyond that. Offsetting this, it had ₹66.7m in cash and ₹456.2m in receivables that were due within 12 months. So its liabilities total ₹881.3m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₹210.6m 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 definitely think shareholders need to watch this one closely. After all, United Polyfab Gujarat 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).

United Polyfab Gujarat shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. The debt burden here is substantial. More concerning, United Polyfab Gujarat saw its EBIT drop by 5.0% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But it is United Polyfab Gujarat'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, United Polyfab Gujarat recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, United Polyfab Gujarat's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Taking into account all the aforementioned factors, it looks like United Polyfab Gujarat has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - United Polyfab Gujarat has 3 warning signs we think you should be aware of.

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. 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.
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