We Think K.C.P. Sugar and Industries (NSE:KCPSUGIND) Is Taking Some Risk With Its 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.' 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 K.C.P. Sugar and Industries Corporation Limited (NSE:KCPSUGIND) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for K.C.P. Sugar and Industries

How Much Debt Does K.C.P. Sugar and Industries Carry?

As you can see below, K.C.P. Sugar and Industries had ₹1.90b of debt at March 2022, down from ₹2.70b a year prior. However, it also had ₹1.02b in cash, and so its net debt is ₹874.6m.

How Healthy Is K.C.P. Sugar and Industries' Balance Sheet?

According to the last reported balance sheet, K.C.P. Sugar and Industries had liabilities of ₹1.79b due within 12 months, and liabilities of ₹833.2m due beyond 12 months. Offsetting these obligations, it had cash of ₹1.02b as well as receivables valued at ₹293.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.31b.

While this might seem like a lot, it is not so bad since K.C.P. Sugar and Industries has a market capitalization of ₹2.28b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

K.C.P. Sugar and Industries shareholders face the double whammy of a high net debt to EBITDA ratio (6.2), and fairly weak interest coverage, since EBIT is just 0.45 times the interest expense. The debt burden here is substantial. One redeeming factor for K.C.P. Sugar and Industries is that it turned last year's EBIT loss into a gain of ₹88m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is K.C.P. Sugar and Industries'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.

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 the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, K.C.P. Sugar and Industries actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither K.C.P. Sugar and Industries's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that K.C.P. Sugar and Industries is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 example, we've discovered 5 warning signs for K.C.P. Sugar and Industries (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.