David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Ambani Organics Limited (NSE:AMBANIORG) makes use of debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Ambani Organics's Debt?
As you can see below, at the end of March 2021, Ambani Organics had ₹315.9m of debt, up from ₹199.3m a year ago. Click the image for more detail. However, because it has a cash reserve of ₹31.1m, its net debt is less, at about ₹284.9m.
How Strong Is Ambani Organics' Balance Sheet?
The latest balance sheet data shows that Ambani Organics had liabilities of ₹440.7m due within a year, and liabilities of ₹151.2m falling due after that. Offsetting this, it had ₹31.1m in cash and ₹300.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹260.0m.
This deficit is considerable relative to its market capitalization of ₹287.7m, so it does suggest shareholders should keep an eye on Ambani Organics' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
While we wouldn't worry about Ambani Organics's net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 1.8 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, one redeeming factor is that Ambani Organics grew its EBIT at 15% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ambani Organics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Ambani Organics burned a lot of cash. 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.
To be frank both Ambani Organics's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Ambani Organics's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 Ambani Organics 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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