Aarti Industries (NSE:AARTIIND) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Aarti Industries Limited (NSE:AARTIIND) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Aarti Industries

How Much Debt Does Aarti Industries Carry?

You can click the graphic below for the historical numbers, but it shows that Aarti Industries had ₹22.2b of debt in March 2022, down from ₹28.4b, one year before. However, because it has a cash reserve of ₹2.57b, its net debt is less, at about ₹19.6b.

How Healthy Is Aarti Industries' Balance Sheet?

According to the last reported balance sheet, Aarti Industries had liabilities of ₹23.4b due within 12 months, and liabilities of ₹14.2b due beyond 12 months. Offsetting this, it had ₹2.57b in cash and ₹13.9b in receivables that were due within 12 months. So it has liabilities totalling ₹21.1b more than its cash and near-term receivables, combined.

Of course, Aarti Industries has a market capitalization of ₹294.3b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Aarti Industries has a low net debt to EBITDA ratio of only 1.0. And its EBIT covers its interest expense a whopping 14.4 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Aarti Industries grew its EBIT by 119% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Aarti Industries can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Aarti Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

The good news is that Aarti Industries's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Aarti Industries can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. To that end, you should learn about the 3 warning signs we've spotted with Aarti Industries (including 2 which shouldn't be ignored) .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.