We Think Agarwal Industrial (NSE:AGARIND) Is Taking Some Risk With Its 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 can see that Agarwal Industrial Corporation Limited (NSE:AGARIND) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Agarwal Industrial

What Is Agarwal Industrial's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Agarwal Industrial had ₹933.1m of debt, an increase on ₹789.5m, over one year. However, it does have ₹191.8m in cash offsetting this, leading to net debt of about ₹741.3m.

How Strong Is Agarwal Industrial's Balance Sheet?

We can see from the most recent balance sheet that Agarwal Industrial had liabilities of ₹1.18b falling due within a year, and liabilities of ₹176.9m due beyond that. Offsetting this, it had ₹191.8m in cash and ₹1.04b in receivables that were due within 12 months. So it has liabilities totalling ₹126.9m more than its cash and near-term receivables, combined.

Given Agarwal Industrial has a market capitalization of ₹839.7m, 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Agarwal Industrial has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Agarwal Industrial saw its EBIT slide 3.9% in the last twelve months. 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 Agarwal Industrial'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.

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. In the last three years, Agarwal Industrial created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Agarwal Industrial's conversion of EBIT to free cash flow and its interest cover were discouraging. But its not so bad at staying on top of its total liabilities. Looking at all the angles mentioned above, it does seem to us that Agarwal Industrial is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Agarwal Industrial that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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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