Is Kothari Sugars and Chemicals (NSE:KOTARISUG) 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Kothari Sugars and Chemicals Limited (NSE:KOTARISUG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Kothari Sugars and Chemicals

How Much Debt Does Kothari Sugars and Chemicals Carry?

You can click the graphic below for the historical numbers, but it shows that Kothari Sugars and Chemicals had ₹592.1m of debt in September 2020, down from ₹1.16b, one year before. On the flip side, it has ₹367.5m in cash leading to net debt of about ₹224.6m.

A Look At Kothari Sugars and Chemicals's Liabilities

The latest balance sheet data shows that Kothari Sugars and Chemicals had liabilities of ₹997.2m due within a year, and liabilities of ₹397.2m falling due after that. Offsetting these obligations, it had cash of ₹367.5m as well as receivables valued at ₹264.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹762.2m.

This deficit isn't so bad because Kothari Sugars and Chemicals is worth ₹1.60b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 1.1 times EBITDA, it is initially surprising to see that Kothari Sugars and Chemicals's EBIT has low interest coverage of 1.7 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, Kothari Sugars and Chemicals's EBIT fell a jaw-dropping 72% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Kothari Sugars and Chemicals'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Kothari Sugars and Chemicals 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

Kothari Sugars and Chemicals's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Kothari Sugars and Chemicals's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 4 warning signs for Kothari Sugars and Chemicals you should know about.

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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