Ambica Agarbathies Aroma & Industries (NSE:AMBICAAGAR) 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.' 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. Importantly, Ambica Agarbathies Aroma & Industries Limited (NSE:AMBICAAGAR) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Ambica Agarbathies Aroma & Industries

How Much Debt Does Ambica Agarbathies Aroma & Industries Carry?

The chart below, which you can click on for greater detail, shows that Ambica Agarbathies Aroma & Industries had ₹660.1m in debt in September 2023; about the same as the year before. On the flip side, it has ₹13.7m in cash leading to net debt of about ₹646.4m.

How Strong Is Ambica Agarbathies Aroma & Industries' Balance Sheet?

The latest balance sheet data shows that Ambica Agarbathies Aroma & Industries had liabilities of ₹242.6m due within a year, and liabilities of ₹869.5m falling due after that. On the other hand, it had cash of ₹13.7m and ₹236.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹861.7m.

When you consider that this deficiency exceeds the company's ₹607.4m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Ambica Agarbathies Aroma & Industries shareholders face the double whammy of a high net debt to EBITDA ratio (7.5), and fairly weak interest coverage, since EBIT is just 1.7 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Ambica Agarbathies Aroma & Industries's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ambica Agarbathies Aroma & Industries will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Ambica Agarbathies Aroma & Industries actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Ambica Agarbathies Aroma & Industries's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Ambica Agarbathies Aroma & Industries's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Ambica Agarbathies Aroma & Industries (of which 2 are a bit concerning!) 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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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.