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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. Balaji Amines Limited (NSE:BALAMINES) makes use of debt. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Balaji Amines’s Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Balaji Amines had debt of ₹2.28b, up from ₹1.52b in one year. However, because it has a cash reserve of ₹144.8m, its net debt is less, at about ₹2.13b.
How Healthy Is Balaji Amines’s Balance Sheet?
We can see from the most recent balance sheet that Balaji Amines had liabilities of ₹3.08b falling due within a year, and liabilities of ₹1.45b due beyond that. On the other hand, it had cash of ₹144.8m and ₹2.25b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.14b.
This deficit isn’t so bad because Balaji Amines is worth ₹10.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Because it carries more debt than cash, we think it’s worth watching Balaji Amines’s balance sheet over time.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Balaji Amines’s net debt is only 1.09 times its EBITDA. And its EBIT easily covers its interest expense, being 16.7 times the size. So we’re pretty relaxed about its super-conservative use of debt. Fortunately, Balaji Amines grew its EBIT by 5.7% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Balaji Amines can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Balaji Amines barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
When it comes to the balance sheet, the standout positive for Balaji Amines was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren’t so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Balaji Amines’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Balaji Amines insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.