Prakash Industries (NSE:PRAKASH) Has A Somewhat Strained Balance Sheet

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.' 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. We can see that Prakash Industries Limited (NSE:PRAKASH) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Prakash Industries

How Much Debt Does Prakash Industries Carry?

As you can see below, Prakash Industries had ₹5.07b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₹1.50b, its net debt is less, at about ₹3.57b.

How Healthy Is Prakash Industries' Balance Sheet?

We can see from the most recent balance sheet that Prakash Industries had liabilities of ₹5.73b falling due within a year, and liabilities of ₹4.33b due beyond that. Offsetting this, it had ₹1.50b in cash and ₹1.75b in receivables that were due within 12 months. So it has liabilities totalling ₹6.82b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of ₹10.1b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Prakash Industries's EBIT has low interest coverage of 1.8 times. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Prakash Industries's EBIT was down 67% 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 you can't view debt in total isolation; since Prakash Industries will need earnings to service that debt. 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. In the last three years, Prakash Industries's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Prakash Industries's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Overall, it seems to us that Prakash Industries's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Prakash Industries has 2 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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