Birla (NSE:BIRLACORPN) 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.' 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. We can see that Birla Corporation Limited (NSE:BIRLACORPN) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Birla

What Is Birla's Net Debt?

The image below, which you can click on for greater detail, shows that Birla had debt of ₹36.2b at the end of March 2021, a reduction from ₹42.8b over a year. However, because it has a cash reserve of ₹11.7b, its net debt is less, at about ₹24.6b.

How Strong Is Birla's Balance Sheet?

According to the last reported balance sheet, Birla had liabilities of ₹20.2b due within 12 months, and liabilities of ₹53.8b due beyond 12 months. Offsetting this, it had ₹11.7b in cash and ₹2.81b in receivables that were due within 12 months. So it has liabilities totalling ₹59.6b more than its cash and near-term receivables, combined.

Birla has a market capitalization of ₹99.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Birla's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 3.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, Birla's EBIT actually dropped 3.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Birla 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Birla produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Birla's interest cover and its level of total liabilities were discouraging. But its not so bad at converting EBIT to free cash flow. Looking at all the angles mentioned above, it does seem to us that Birla is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Birla that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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