We Think Reliance Industries (NSE:RELIANCE) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Reliance Industries Limited (NSE:RELIANCE) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Reliance Industries

How Much Debt Does Reliance Industries Carry?

The chart below, which you can click on for greater detail, shows that Reliance Industries had ₹3.46t in debt in March 2024; about the same as the year before. However, it also had ₹2.03t in cash, and so its net debt is ₹1.43t.

How Strong Is Reliance Industries' Balance Sheet?

We can see from the most recent balance sheet that Reliance Industries had liabilities of ₹3.97t falling due within a year, and liabilities of ₹4.33t due beyond that. On the other hand, it had cash of ₹2.03t and ₹341.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹5.93t.

This deficit isn't so bad because Reliance Industries is worth a massive ₹20t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).

While Reliance Industries's low debt to EBITDA ratio of 0.87 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.8 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way Reliance Industries could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 10%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Reliance Industries can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Reliance Industries actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Reliance Industries's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. Looking at all the angles mentioned above, it does seem to us that Reliance Industries is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Reliance Industries you should know about.

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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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.