Does Gujarat Alkalies and Chemicals (NSE:GUJALKALI) Have A Healthy Balance Sheet?

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.' 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. Importantly, Gujarat Alkalies and Chemicals Limited (NSE:GUJALKALI) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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, 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Gujarat Alkalies and Chemicals

What Is Gujarat Alkalies and Chemicals's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Gujarat Alkalies and Chemicals had debt of ₹4.33b, up from ₹2.05b in one year. On the flip side, it has ₹4.31b in cash leading to net debt of about ₹20.1m.

A Look At Gujarat Alkalies and Chemicals' Liabilities

Zooming in on the latest balance sheet data, we can see that Gujarat Alkalies and Chemicals had liabilities of ₹6.11b due within 12 months and liabilities of ₹11.7b due beyond that. Offsetting these obligations, it had cash of ₹4.31b as well as receivables valued at ₹3.65b due within 12 months. So it has liabilities totalling ₹9.83b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Gujarat Alkalies and Chemicals is worth ₹32.9b, and thus could probably raise enough capital to shore up 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. Carrying virtually no net debt, Gujarat Alkalies and Chemicals has a very light debt load indeed.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

With debt at a measly 0.0056 times EBITDA and EBIT covering interest a whopping 11.9 times, it's clear that Gujarat Alkalies and Chemicals is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In fact Gujarat Alkalies and Chemicals's saving grace is its low debt levels, because its EBIT has tanked 56% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Gujarat Alkalies and Chemicals 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Gujarat Alkalies and Chemicals created free cash flow amounting to 8.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Gujarat Alkalies and Chemicals's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its net debt to EBITDA was refreshing. When we consider all the factors discussed, it seems to us that Gujarat Alkalies and Chemicals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Gujarat Alkalies and Chemicals (of which 1 shouldn't be ignored!) you should know about.

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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