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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We can see that Birla Corporation Limited (NSE:BIRLACORPN) 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 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Birla’s Net Debt?
As you can see below, Birla had ₹36.5b of debt at March 2019, down from ₹41.3b a year prior. However, it also had ₹12.0b in cash, and so its net debt is ₹24.5b.
A Look At Birla’s Liabilities
We can see from the most recent balance sheet that Birla had liabilities of ₹17.9b falling due within a year, and liabilities of ₹50.5b due beyond that. Offsetting these obligations, it had cash of ₹12.0b as well as receivables valued at ₹2.63b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹53.7b.
Given this deficit is actually higher than the company’s market capitalization of ₹50.1b, we think shareholders really should watch Birla’s debt levels, like a parent watching their child ride a bike for the first time. 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. Because it carries more debt than cash, we think it’s worth watching Birla’s balance sheet over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
While Birla’s debt to EBITDA ratio (2.60) suggests that it uses debt fairly modestly, its interest cover is very weak, at 1.64. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On the other hand, Birla grew its EBIT by 24% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Birla actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Birla’s conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its interest cover had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Birla’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Birla’s earnings per share history for free.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.