Chemfab Alkalis (NSE:CHEMFAB) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Chemfab Alkalis Limited (NSE:CHEMFAB) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Chemfab Alkalis

How Much Debt Does Chemfab Alkalis Carry?

As you can see below, Chemfab Alkalis had ₹270.6m of debt at September 2020, down from ₹340.5m a year prior. However, because it has a cash reserve of ₹172.8m, its net debt is less, at about ₹97.8m.

How Healthy Is Chemfab Alkalis' Balance Sheet?

The latest balance sheet data shows that Chemfab Alkalis had liabilities of ₹469.1m due within a year, and liabilities of ₹214.6m falling due after that. Offsetting these obligations, it had cash of ₹172.8m as well as receivables valued at ₹128.9m due within 12 months. So it has liabilities totalling ₹382.0m more than its cash and near-term receivables, combined.

Of course, Chemfab Alkalis has a market capitalization of ₹2.00b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chemfab Alkalis has a low net debt to EBITDA ratio of only 0.27. And its EBIT easily covers its interest expense, being 12.0 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Chemfab Alkalis's saving grace is its low debt levels, because its EBIT has tanked 73% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chemfab Alkalis will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Chemfab Alkalis actually recorded a cash outflow, overall. 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

We feel some trepidation about Chemfab Alkalis's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. When we consider all the factors discussed, it seems to us that Chemfab Alkalis is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Chemfab Alkalis that you should be aware of before investing here.

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. 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.
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