These 4 Measures Indicate That Bodal Chemicals (NSE:BODALCHEM) Is Using Debt Extensively

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 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 note that Bodal Chemicals Limited (NSE:BODALCHEM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Bodal Chemicals

How Much Debt Does Bodal Chemicals Carry?

The image below, which you can click on for greater detail, shows that Bodal Chemicals had debt of ₹1.88b at the end of September 2020, a reduction from ₹2.67b over a year. However, because it has a cash reserve of ₹125.9m, its net debt is less, at about ₹1.75b.

A Look At Bodal Chemicals' Liabilities

We can see from the most recent balance sheet that Bodal Chemicals had liabilities of ₹3.78b falling due within a year, and liabilities of ₹389.3m due beyond that. Offsetting these obligations, it had cash of ₹125.9m as well as receivables valued at ₹3.76b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹278.5m.

Of course, Bodal Chemicals has a market capitalization of ₹10.8b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change 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).

With a debt to EBITDA ratio of 1.9, Bodal Chemicals uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.6 times interest expense) certainly does not do anything to dispel this impression. Shareholders should be aware that Bodal Chemicals's EBIT was down 47% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Bodal Chemicals's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Bodal Chemicals recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

While Bodal Chemicals's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. At least its interest cover gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Bodal Chemicals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Bodal Chemicals is showing 2 warning signs in our investment analysis , you should know about...

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.

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