Is Chemplast Sanmar (NSE:CHEMPLASTS) A Risky Investment?

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 Chemplast Sanmar Limited (NSE:CHEMPLASTS) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Chemplast Sanmar

What Is Chemplast Sanmar's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Chemplast Sanmar had debt of ₹12.8b, up from ₹9.25b in one year. However, because it has a cash reserve of ₹9.55b, its net debt is less, at about ₹3.21b.

A Look At Chemplast Sanmar's Liabilities

We can see from the most recent balance sheet that Chemplast Sanmar had liabilities of ₹20.8b falling due within a year, and liabilities of ₹18.1b due beyond that. Offsetting this, it had ₹9.55b in cash and ₹884.6m in receivables that were due within 12 months. So it has liabilities totalling ₹28.4b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Chemplast Sanmar is worth ₹70.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 Chemplast Sanmar has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 2.3. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Shareholders should be aware that Chemplast Sanmar's EBIT was down 92% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chemplast Sanmar'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Chemplast Sanmar recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Chemplast Sanmar's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Looking at the bigger picture, it seems clear to us that Chemplast Sanmar's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. While Chemplast Sanmar didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.