Here's Why Gujarat Fluorochemicals (NSE:FLUOROCHEM) Can Manage Its Debt Responsibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Gujarat Fluorochemicals Limited (NSE:FLUOROCHEM) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Gujarat Fluorochemicals

What Is Gujarat Fluorochemicals's Debt?

As you can see below, Gujarat Fluorochemicals had ₹16.3b of debt at September 2023, down from ₹17.1b a year prior. However, it does have ₹1.96b in cash offsetting this, leading to net debt of about ₹14.3b.

How Strong Is Gujarat Fluorochemicals' Balance Sheet?

According to the last reported balance sheet, Gujarat Fluorochemicals had liabilities of ₹24.0b due within 12 months, and liabilities of ₹4.89b due beyond 12 months. Offsetting these obligations, it had cash of ₹1.96b as well as receivables valued at ₹7.57b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹19.3b.

Of course, Gujarat Fluorochemicals has a market capitalization of ₹409.7b, 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.

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.

Gujarat Fluorochemicals has a low net debt to EBITDA ratio of only 0.96. And its EBIT covers its interest expense a whopping 17.6 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Gujarat Fluorochemicals has seen its EBIT plunge 11% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Gujarat Fluorochemicals can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Gujarat Fluorochemicals reported free cash flow worth 2.0% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Gujarat Fluorochemicals was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Gujarat Fluorochemicals's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Gujarat Fluorochemicals, you may well want to click here to check an interactive graph of its earnings per share history.

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.