Is Chambal Fertilisers and Chemicals (NSE:CHAMBLFERT) Using Too Much Debt?

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

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Chambal Fertilisers and Chemicals

How Much Debt Does Chambal Fertilisers and Chemicals Carry?

The image below, which you can click on for greater detail, shows that at March 2022 Chambal Fertilisers and Chemicals had debt of ₹43.2b, up from ₹39.2b in one year. On the flip side, it has ₹5.54b in cash leading to net debt of about ₹37.7b.

How Strong Is Chambal Fertilisers and Chemicals' Balance Sheet?

The latest balance sheet data shows that Chambal Fertilisers and Chemicals had liabilities of ₹38.0b due within a year, and liabilities of ₹31.0b falling due after that. On the other hand, it had cash of ₹5.54b and ₹21.5b worth of receivables due within a year. So it has liabilities totalling ₹42.0b more than its cash and near-term receivables, combined.

Chambal Fertilisers and Chemicals has a market capitalization of ₹144.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Chambal Fertilisers and Chemicals's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 18.5 times, makes us even more comfortable. On the other hand, Chambal Fertilisers and Chemicals's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Chambal Fertilisers and Chemicals 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. Happily for any shareholders, Chambal Fertilisers and Chemicals actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Chambal Fertilisers and Chemicals's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Chambal Fertilisers and Chemicals can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Chambal Fertilisers and Chemicals (including 1 which makes us a bit uncomfortable) .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.