Here's Why K.M. Sugar Mills (NSE:KMSUGAR) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, K.M. Sugar Mills Limited (NSE:KMSUGAR) does carry debt. But the real question is whether this debt is making the company risky.

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for K.M. Sugar Mills

What Is K.M. Sugar Mills's Net Debt?

You can click the graphic below for the historical numbers, but it shows that K.M. Sugar Mills had ₹606.0m of debt in September 2020, down from ₹2.04b, one year before. However, because it has a cash reserve of ₹149.8m, its net debt is less, at about ₹456.2m.

How Strong Is K.M. Sugar Mills's Balance Sheet?

We can see from the most recent balance sheet that K.M. Sugar Mills had liabilities of ₹1.03b falling due within a year, and liabilities of ₹602.0m due beyond that. Offsetting this, it had ₹149.8m in cash and ₹387.7m in receivables that were due within 12 months. So its liabilities total ₹1.09b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₹1.05b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

While K.M. Sugar Mills's low debt to EBITDA ratio of 0.75 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, K.M. Sugar Mills grew its EBIT by 70% 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 it is K.M. Sugar Mills'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, K.M. Sugar Mills saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over K.M. Sugar Mills's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making K.M. Sugar Mills stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that K.M. Sugar Mills is showing 1 warning sign in our investment analysis , you should know about...

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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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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