These 4 Measures Indicate That Oriental Aromatics (NSE:OAL) Is Using Debt Reasonably Well

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 Oriental Aromatics Limited (NSE:OAL) makes use of debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Oriental Aromatics

What Is Oriental Aromatics's Debt?

As you can see below, Oriental Aromatics had ₹123.5m of debt at September 2020, down from ₹507.6m a year prior. However, because it has a cash reserve of ₹120.1m, its net debt is less, at about ₹3.47m.

How Strong Is Oriental Aromatics's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Oriental Aromatics had liabilities of ₹932.8m due within 12 months and liabilities of ₹283.7m due beyond that. Offsetting this, it had ₹120.1m in cash and ₹1.34b in receivables that were due within 12 months. So it can boast ₹243.6m more liquid assets than total liabilities.

This state of affairs indicates that Oriental Aromatics's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹15.4b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Oriental Aromatics has a very light debt load indeed.

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.

Oriental Aromatics has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.0026 and EBIT of 293 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Fortunately, Oriental Aromatics grew its EBIT by 8.7% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is Oriental Aromatics's earnings that will influence how the balance sheet holds up in the future. 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.

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 most recent three years, Oriental Aromatics recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Oriental Aromatics's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Oriental Aromatics seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Oriental Aromatics is showing 2 warning signs in our investment analysis , you should know about...

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.

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This article by Simply Wall St is general in nature. 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.
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