These 4 Measures Indicate That Shree Ram Proteins (NSE:SRPL) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Shree Ram Proteins Limited (NSE:SRPL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shree Ram Proteins

How Much Debt Does Shree Ram Proteins Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 Shree Ram Proteins had ₹427.0m of debt, an increase on ₹395.2m, over one year. However, it also had ₹9.97m in cash, and so its net debt is ₹417.0m.

A Look At Shree Ram Proteins' Liabilities

We can see from the most recent balance sheet that Shree Ram Proteins had liabilities of ₹417.0m falling due within a year, and liabilities of ₹123.1m due beyond that. On the other hand, it had cash of ₹9.97m and ₹434.3m worth of receivables due within a year. So its liabilities total ₹95.9m more than the combination of its cash and short-term receivables.

Of course, Shree Ram Proteins has a market capitalization of ₹721.9m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 7.1 hit our confidence in Shree Ram Proteins like a one-two punch to the gut. The debt burden here is substantial. Worse, Shree Ram Proteins's EBIT was down 26% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Shree Ram Proteins'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shree Ram Proteins produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Shree Ram Proteins's interest cover makes us cautious about it, its track record of (not) growing its EBIT is no better. But on the brighter side of life, its conversion of EBIT to free cash flow leaves us feeling more frolicsome. When we consider all the factors discussed, it seems to us that Shree Ram Proteins is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Shree Ram Proteins has 4 warning signs (and 3 which can't be ignored) we think you should know about.

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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