Is K.M. Sugar Mills (NSE:KMSUGAR) A Risky Investment?

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.' 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 K.M. Sugar Mills Limited (NSE:KMSUGAR) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

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

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

The image below, which you can click on for greater detail, shows that K.M. Sugar Mills had debt of ₹1.79b at the end of March 2021, a reduction from ₹2.00b over a year. However, because it has a cash reserve of ₹59.1m, its net debt is less, at about ₹1.73b.

How Healthy Is K.M. Sugar Mills' Balance Sheet?

The latest balance sheet data shows that K.M. Sugar Mills had liabilities of ₹3.55b due within a year, and liabilities of ₹564.3m falling due after that. Offsetting this, it had ₹59.1m in cash and ₹531.6m in receivables that were due within 12 months. So its liabilities total ₹3.52b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's ₹3.27b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

K.M. Sugar Mills's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, K.M. Sugar Mills grew its EBIT at 16% over the last year, further increasing its ability to manage 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 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. 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

We'd go so far as to say K.M. Sugar Mills's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that K.M. Sugar Mills's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 3 warning signs for K.M. Sugar Mills you should be aware of, and 1 of them is a bit unpleasant.

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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