Does Kanoria Chemicals & Industries (NSE:KANORICHEM) Have A Healthy Balance Sheet?

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.' 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 Kanoria Chemicals & Industries Limited (NSE:KANORICHEM) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Kanoria Chemicals & Industries

What Is Kanoria Chemicals & Industries's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Kanoria Chemicals & Industries had debt of ₹5.03b, up from ₹4.80b in one year. However, it does have ₹200.1m in cash offsetting this, leading to net debt of about ₹4.83b.

How Strong Is Kanoria Chemicals & Industries' Balance Sheet?

We can see from the most recent balance sheet that Kanoria Chemicals & Industries had liabilities of ₹3.52b falling due within a year, and liabilities of ₹4.06b due beyond that. On the other hand, it had cash of ₹200.1m and ₹1.84b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹5.55b.

This deficit is considerable relative to its market capitalization of ₹6.03b, so it does suggest shareholders should keep an eye on Kanoria Chemicals & Industries' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Weak interest cover of 1.0 times and a disturbingly high net debt to EBITDA ratio of 6.0 hit our confidence in Kanoria Chemicals & Industries like a one-two punch to the gut. The debt burden here is substantial. The good news is that Kanoria Chemicals & Industries grew its EBIT a smooth 64% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Kanoria Chemicals & Industries's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Kanoria Chemicals & Industries actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Kanoria Chemicals & Industries's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But its conversion of EBIT to free cash flow was significantly redeeming. When we consider all the factors mentioned above, we do feel a bit cautious about Kanoria Chemicals & Industries'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. 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. Case in point: We've spotted 3 warning signs for Kanoria Chemicals & Industries you should be aware of, and 1 of them makes us a bit uncomfortable.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.