Here's Why Privi Speciality Chemicals (NSE:PRIVISCL) Has A Meaningful Debt Burden

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.' 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 note that Privi Speciality Chemicals Limited (NSE:PRIVISCL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for Privi Speciality Chemicals

What Is Privi Speciality Chemicals's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Privi Speciality Chemicals had debt of ₹6.90b, up from ₹3.89b in one year. However, because it has a cash reserve of ₹200.0m, its net debt is less, at about ₹6.70b.

A Look At Privi Speciality Chemicals' Liabilities

According to the last reported balance sheet, Privi Speciality Chemicals had liabilities of ₹6.31b due within 12 months, and liabilities of ₹3.87b due beyond 12 months. On the other hand, it had cash of ₹200.0m and ₹2.09b worth of receivables due within a year. So its liabilities total ₹7.90b more than the combination of its cash and short-term receivables.

Given Privi Speciality Chemicals has a market capitalization of ₹72.4b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 3.0 Privi Speciality Chemicals has a fairly noticeable amount of debt. But the high interest coverage of 8.5 suggests it can easily service that debt. Unfortunately, Privi Speciality Chemicals's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Privi Speciality Chemicals can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Privi Speciality Chemicals burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Privi Speciality Chemicals's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. Taking the abovementioned factors together we do think Privi Speciality Chemicals's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. 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 1 warning sign for Privi Speciality Chemicals you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.