These 4 Measures Indicate That Gokul Refoils & Solvent (NSE:GOKUL) 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Gokul Refoils & Solvent Limited (NSE:GOKUL) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. 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 Gokul Refoils & Solvent

What Is Gokul Refoils & Solvent's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Gokul Refoils & Solvent had debt of ₹2.71b, up from ₹2.39b in one year. However, it does have ₹1.21b in cash offsetting this, leading to net debt of about ₹1.50b.

How Strong Is Gokul Refoils & Solvent's Balance Sheet?

The latest balance sheet data shows that Gokul Refoils & Solvent had liabilities of ₹3.42b due within a year, and liabilities of ₹52.5m falling due after that. Offsetting these obligations, it had cash of ₹1.21b as well as receivables valued at ₹1.38b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹882.3m.

This deficit isn't so bad because Gokul Refoils & Solvent is worth ₹1.79b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Gokul Refoils & Solvent's net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 16.5 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Gokul Refoils & Solvent grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Gokul Refoils & Solvent will need earnings to service that debt. 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Gokul Refoils & Solvent actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Gokul Refoils & Solvent's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Taking all this data into account, it seems to us that Gokul Refoils & Solvent takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Case in point: We've spotted 4 warning signs for Gokul Refoils & Solvent you should be aware of, and 1 of them can't be ignored.

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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