Here's Why Peria Karamalai Tea and Produce (NSE:PKTEA) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies The Peria Karamalai Tea and Produce Company Limited (NSE:PKTEA) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Peria Karamalai Tea and Produce

What Is Peria Karamalai Tea and Produce's Net Debt?

As you can see below, Peria Karamalai Tea and Produce had ₹175.0m of debt at September 2020, down from ₹244.4m a year prior. However, it also had ₹34.8m in cash, and so its net debt is ₹140.3m.

A Look At Peria Karamalai Tea and Produce's Liabilities

Zooming in on the latest balance sheet data, we can see that Peria Karamalai Tea and Produce had liabilities of ₹164.3m due within 12 months and liabilities of ₹109.4m due beyond that. On the other hand, it had cash of ₹34.8m and ₹378.4m worth of receivables due within a year. So it actually has ₹139.4m more liquid assets than total liabilities.

This surplus suggests that Peria Karamalai Tea and Produce is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

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.

While Peria Karamalai Tea and Produce's low debt to EBITDA ratio of 0.86 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that Peria Karamalai Tea and Produce's EBIT shot up like bamboo after rain, gaining 60% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Peria Karamalai Tea and Produce will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Peria Karamalai Tea and Produce 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

Happily, Peria Karamalai Tea and Produce's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Peria Karamalai Tea and Produce can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Peria Karamalai Tea and Produce you should be aware of, and 1 of them is significant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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