Is Godrej Consumer Products (NSE:GODREJCP) Using Too Much Debt?

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. We note that Godrej Consumer Products Limited (NSE:GODREJCP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Godrej Consumer Products

What Is Godrej Consumer Products's Net Debt?

The image below, which you can click on for greater detail, shows that Godrej Consumer Products had debt of ₹19.0b at the end of March 2021, a reduction from ₹36.7b over a year. However, it also had ₹13.3b in cash, and so its net debt is ₹5.67b.

How Strong Is Godrej Consumer Products' Balance Sheet?

According to the last reported balance sheet, Godrej Consumer Products had liabilities of ₹41.4b due within 12 months, and liabilities of ₹7.08b due beyond 12 months. Offsetting these obligations, it had cash of ₹13.3b as well as receivables valued at ₹10.7b due within 12 months. So its liabilities total ₹24.4b more than the combination of its cash and short-term receivables.

Of course, Godrej Consumer Products has a titanic market capitalization of ₹1.05t, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Godrej Consumer Products has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Godrej Consumer Products's net debt is only 0.22 times its EBITDA. And its EBIT easily covers its interest expense, being 59.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Godrej Consumer Products grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Godrej Consumer Products can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Godrej Consumer Products generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Godrej Consumer Products's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! It looks Godrej Consumer Products has no trouble standing on its own two feet, and it has no reason to fear its lenders. To our minds it has a healthy happy balance sheet. We'd be very excited to see if Godrej Consumer Products insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.

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.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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