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 Britannia Industries Limited (NSE:BRITANNIA) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Britannia Industries's Net Debt?
As you can see below, at the end of March 2021, Britannia Industries had ₹20.9b of debt, up from ₹15.5b a year ago. Click the image for more detail. However, it does have ₹16.0b in cash offsetting this, leading to net debt of about ₹4.83b.
A Look At Britannia Industries' Liabilities
We can see from the most recent balance sheet that Britannia Industries had liabilities of ₹36.1b falling due within a year, and liabilities of ₹8.11b due beyond that. On the other hand, it had cash of ₹16.0b and ₹16.0b worth of receivables due within a year. So its liabilities total ₹12.2b more than the combination of its cash and short-term receivables.
Having regard to Britannia Industries' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the ₹984.3b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Britannia Industries has a very light debt load indeed.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Britannia Industries's net debt is only 0.21 times its EBITDA. And its EBIT easily covers its interest expense, being 91.3 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Britannia Industries grew its EBIT by 8.6% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Britannia 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. During the last three years, Britannia Industries produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Britannia Industries's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Britannia Industries's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. To that end, you should be aware of the 2 warning signs we've spotted with Britannia Industries .
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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