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.' 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 note that Aakash Exploration Services Limited (NSE:AAKASH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is Aakash Exploration Services's Debt?
The image below, which you can click on for greater detail, shows that Aakash Exploration Services had debt of ₹144.6m at the end of September 2021, a reduction from ₹213.8m over a year. However, it also had ₹16.0m in cash, and so its net debt is ₹128.6m.
How Healthy Is Aakash Exploration Services' Balance Sheet?
The latest balance sheet data shows that Aakash Exploration Services had liabilities of ₹116.5m due within a year, and liabilities of ₹111.7m falling due after that. Offsetting this, it had ₹16.0m in cash and ₹158.6m in receivables that were due within 12 months. So its liabilities total ₹53.6m more than the combination of its cash and short-term receivables.
Given Aakash Exploration Services has a market capitalization of ₹2.11b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Aakash Exploration Services's low debt to EBITDA ratio of 0.90 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. But the other side of the story is that Aakash Exploration Services saw its EBIT decline by 6.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Aakash Exploration Services'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Aakash Exploration Services reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Both Aakash Exploration Services's ability to handle its debt, based on its EBITDA, and its level of total liabilities gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Aakash Exploration Services's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Aakash Exploration Services .
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.
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.
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