Here's Why Atul (NSE:ATUL) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Atul Ltd (NSE:ATUL) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out the opportunities and risks within the IN Chemicals industry.

How Much Debt Does Atul Carry?

The image below, which you can click on for greater detail, shows that at September 2022 Atul had debt of ₹677.0m, up from ₹312.5m in one year. However, its balance sheet shows it holds ₹2.48b in cash, so it actually has ₹1.80b net cash.

A Look At Atul's Liabilities

We can see from the most recent balance sheet that Atul had liabilities of ₹9.70b falling due within a year, and liabilities of ₹2.24b due beyond that. Offsetting these obligations, it had cash of ₹2.48b as well as receivables valued at ₹9.87b due within 12 months. So it can boast ₹402.7m more liquid assets than total liabilities.

This state of affairs indicates that Atul's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹246.2b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Atul has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Atul saw its EBIT drop by 3.9% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Atul 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Atul has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Atul reported free cash flow worth 7.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Atul has ₹1.80b in net cash and a decent-looking balance sheet. So we are not troubled with Atul's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Atul (of which 1 can't be ignored!) 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.