Chambal Fertilisers and Chemicals (NSE:CHAMBLFERT) Takes On Some Risk With Its Use Of Debt
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 can see that Chambal Fertilisers and Chemicals Limited (NSE:CHAMBLFERT) 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Chambal Fertilisers and Chemicals
How Much Debt Does Chambal Fertilisers and Chemicals Carry?
The chart below, which you can click on for greater detail, shows that Chambal Fertilisers and Chemicals had ₹93.9b in debt in March 2020; about the same as the year before. However, it also had ₹4.98b in cash, and so its net debt is ₹88.9b.
A Look At Chambal Fertilisers and Chemicals's Liabilities
According to the last reported balance sheet, Chambal Fertilisers and Chemicals had liabilities of ₹66.8b due within 12 months, and liabilities of ₹44.2b due beyond 12 months. On the other hand, it had cash of ₹4.98b and ₹55.6b worth of receivables due within a year. So its liabilities total ₹50.4b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₹58.0b, so it does suggest shareholders should keep an eye on Chambal Fertilisers and Chemicals's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Chambal Fertilisers and Chemicals has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, Chambal Fertilisers and Chemicals boosted its EBIT by a silky 51% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chambal Fertilisers and Chemicals's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Chambal Fertilisers and Chemicals saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Mulling over Chambal Fertilisers and Chemicals's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Chambal Fertilisers and Chemicals stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Chambal Fertilisers and Chemicals (1 is significant!) that you should be aware of before investing here.
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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