Orient Abrasives (NSE:ORIENTABRA) Seems To Use Debt Quite Sensibly

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. Importantly, Orient Abrasives Limited (NSE:ORIENTABRA) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Orient Abrasives

What Is Orient Abrasives's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Orient Abrasives had ₹377.3m of debt, an increase on ₹267.9m, over one year. However, it also had ₹59.7m in cash, and so its net debt is ₹317.6m.

How Strong Is Orient Abrasives' Balance Sheet?

According to the last reported balance sheet, Orient Abrasives had liabilities of ₹804.8m due within 12 months, and liabilities of ₹128.3m due beyond 12 months. On the other hand, it had cash of ₹59.7m and ₹792.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹81.1m.

Of course, Orient Abrasives has a market capitalization of ₹3.87b, 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 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 Orient Abrasives has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 2.0. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Shareholders should be aware that Orient Abrasives's EBIT was down 69% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is Orient Abrasives'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Orient Abrasives recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

We weren't impressed with Orient Abrasives's interest cover, and its EBIT growth rate made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Orient Abrasives's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Orient Abrasives (of which 1 is a bit concerning!) you should know about.

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.