These 4 Measures Indicate That AVT Natural Products (NSE:AVTNPL) Is Using Debt Reasonably Well

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that AVT Natural Products Limited (NSE:AVTNPL) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

View our latest analysis for AVT Natural Products

What Is AVT Natural Products's Debt?

The image below, which you can click on for greater detail, shows that AVT Natural Products had debt of ₹630.5m at the end of September 2020, a reduction from ₹748.1m over a year. However, it also had ₹350.2m in cash, and so its net debt is ₹280.4m.

A Look At AVT Natural Products' Liabilities

Zooming in on the latest balance sheet data, we can see that AVT Natural Products had liabilities of ₹1.31b due within 12 months and liabilities of ₹222.5m due beyond that. Offsetting this, it had ₹350.2m in cash and ₹931.4m in receivables that were due within 12 months. So its liabilities total ₹247.0m more than the combination of its cash and short-term receivables.

Of course, AVT Natural Products has a market capitalization of ₹7.79b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

AVT Natural Products's net debt is only 0.47 times its EBITDA. And its EBIT covers its interest expense a whopping 22.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that AVT Natural Products grew its EBIT at 16% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is AVT Natural Products'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, AVT Natural Products recorded negative free cash flow, in total. 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

Happily, AVT Natural Products's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that AVT Natural Products can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with AVT Natural Products , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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