Is Harrisons Malayalam (NSE:HARRMALAYA) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Harrisons Malayalam Limited (NSE:HARRMALAYA) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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.

Check out our latest analysis for Harrisons Malayalam

How Much Debt Does Harrisons Malayalam Carry?

The image below, which you can click on for greater detail, shows that Harrisons Malayalam had debt of ₹943.5m at the end of September 2020, a reduction from ₹1.03b over a year. However, it does have ₹212.6m in cash offsetting this, leading to net debt of about ₹731.0m.

How Strong Is Harrisons Malayalam's Balance Sheet?

According to the last reported balance sheet, Harrisons Malayalam had liabilities of ₹2.30b due within 12 months, and liabilities of ₹1.02b due beyond 12 months. On the other hand, it had cash of ₹212.6m and ₹140.3m worth of receivables due within a year. So its liabilities total ₹2.96b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of ₹2.84b, we think shareholders really should watch Harrisons Malayalam's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Harrisons Malayalam's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 2.6 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, Harrisons Malayalam's EBIT launched higher than Elon Musk, gaining a whopping 106% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Harrisons Malayalam'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent two years, Harrisons Malayalam recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Harrisons Malayalam's ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Harrisons Malayalam's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 3 warning signs for Harrisons Malayalam (1 is concerning) you should be aware of.

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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This article by Simply Wall St is general in nature. 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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