Here's Why Prakash Industries (NSE:PRAKASH) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Prakash Industries Limited (NSE:PRAKASH) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Prakash Industries

What Is Prakash Industries's Net Debt?

As you can see below, Prakash Industries had ₹5.48b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₹2.11b in cash leading to net debt of about ₹3.37b.

How Strong Is Prakash Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Prakash Industries had liabilities of ₹6.28b due within 12 months and liabilities of ₹4.72b due beyond that. Offsetting these obligations, it had cash of ₹2.11b as well as receivables valued at ₹663.0m due within 12 months. So it has liabilities totalling ₹8.23b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹10.3b, so it does suggest shareholders should keep an eye on Prakash Industries' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Looking at its net debt to EBITDA of 0.85 and interest cover of 3.2 times, it seems to us that Prakash Industries is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Also relevant is that Prakash Industries has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is Prakash 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Prakash Industries produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Prakash Industries's EBIT growth rate was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its interest cover somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Prakash Industries is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Prakash Industries (including 1 which can't be ignored) .

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.