David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies JK Lakshmi Cement Limited (NSE:JKLAKSHMI) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is JK Lakshmi Cement's Debt?
The image below, which you can click on for greater detail, shows that JK Lakshmi Cement had debt of ₹12.6b at the end of March 2021, a reduction from ₹19.9b over a year. However, because it has a cash reserve of ₹8.60b, its net debt is less, at about ₹3.98b.
A Look At JK Lakshmi Cement's Liabilities
Zooming in on the latest balance sheet data, we can see that JK Lakshmi Cement had liabilities of ₹14.8b due within 12 months and liabilities of ₹17.0b due beyond that. Offsetting these obligations, it had cash of ₹8.60b as well as receivables valued at ₹978.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹22.2b.
This deficit isn't so bad because JK Lakshmi Cement is worth ₹67.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
While JK Lakshmi Cement's low debt to EBITDA ratio of 0.42 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Also relevant is that JK Lakshmi Cement has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. 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 JK Lakshmi Cement'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. Happily for any shareholders, JK Lakshmi Cement actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
The good news is that JK Lakshmi Cement's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its interest cover. Taking all this data into account, it seems to us that JK Lakshmi Cement takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with JK Lakshmi Cement .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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