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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that I G Petrochemicals Limited (NSE:IGPL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is I G Petrochemicals's Debt?
You can click the graphic below for the historical numbers, but it shows that I G Petrochemicals had ₹1.75b of debt in September 2021, down from ₹2.22b, one year before. However, it also had ₹1.40b in cash, and so its net debt is ₹341.2m.
How Strong Is I G Petrochemicals' Balance Sheet?
According to the last reported balance sheet, I G Petrochemicals had liabilities of ₹3.92b due within 12 months, and liabilities of ₹1.60b due beyond 12 months. On the other hand, it had cash of ₹1.40b and ₹2.77b worth of receivables due within a year. So it has liabilities totalling ₹1.36b more than its cash and near-term receivables, combined.
Of course, I G Petrochemicals has a market capitalization of ₹19.7b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
I G Petrochemicals has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.08 and EBIT of 100 times the interest expense. So relative to past earnings, the debt load seems trivial. Even more impressive was the fact that I G Petrochemicals grew its EBIT by 179% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since I G Petrochemicals will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, I G Petrochemicals reported free cash flow worth 9.3% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
I G Petrochemicals's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that I G Petrochemicals takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for I G Petrochemicals that you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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.