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 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. We can see that Asian Paints Limited (NSE:ASIANPAINT) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
What Is Asian Paints's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Asian Paints had debt of ₹6.44b, up from ₹3.46b in one year. However, it does have ₹34.7b in cash offsetting this, leading to net cash of ₹28.3b.
A Look At Asian Paints' Liabilities
The latest balance sheet data shows that Asian Paints had liabilities of ₹69.5b due within a year, and liabilities of ₹12.3b falling due after that. Offsetting these obligations, it had cash of ₹34.7b as well as receivables valued at ₹31.0b due within 12 months. So it has liabilities totalling ₹16.2b more than its cash and near-term receivables, combined.
Having regard to Asian Paints' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the ₹3.15t company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Asian Paints boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, Asian Paints grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Asian Paints can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Asian Paints may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Asian Paints produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Asian Paints has ₹28.3b in net cash. And we liked the look of last year's 36% year-on-year EBIT growth. So we don't think Asian Paints's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in Asian Paints, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.