Aarti Industries (NSE:AARTIIND) Has A Somewhat Strained Balance Sheet

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.' 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. As with many other companies Aarti Industries Limited (NSE:AARTIIND) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Aarti Industries

What Is Aarti Industries's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Aarti Industries had debt of ₹30.3b, up from ₹21.0b in one year. However, it also had ₹4.12b in cash, and so its net debt is ₹26.2b.

How Healthy Is Aarti Industries' Balance Sheet?

The latest balance sheet data shows that Aarti Industries had liabilities of ₹24.0b due within a year, and liabilities of ₹17.3b falling due after that. Offsetting these obligations, it had cash of ₹4.12b as well as receivables valued at ₹9.81b due within 12 months. So it has liabilities totalling ₹27.3b more than its cash and near-term receivables, combined.

Given Aarti Industries has a market capitalization of ₹298.5b, it's hard to believe these liabilities pose much threat. 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). 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).

Aarti Industries has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. Sadly, Aarti Industries's EBIT actually dropped 5.3% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Aarti Industries's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Aarti Industries saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Aarti Industries's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. When we consider all the factors discussed, it seems to us that Aarti Industries is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Aarti Industries , and understanding them should be part of your investment process.

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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