Privi Speciality Chemicals (NSE:PRIVISCL) Takes On Some Risk With Its Use Of Debt

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. We note that Privi Speciality Chemicals Limited (NSE:PRIVISCL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Privi Speciality Chemicals

How Much Debt Does Privi Speciality Chemicals Carry?

The image below, which you can click on for greater detail, shows that Privi Speciality Chemicals had debt of ₹9.81b at the end of March 2024, a reduction from ₹10.7b over a year. However, because it has a cash reserve of ₹683.5m, its net debt is less, at about ₹9.12b.

How Healthy Is Privi Speciality Chemicals' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Privi Speciality Chemicals had liabilities of ₹8.96b due within 12 months and liabilities of ₹5.05b due beyond that. Offsetting this, it had ₹683.5m in cash and ₹3.48b in receivables that were due within 12 months. So its liabilities total ₹9.86b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Privi Speciality Chemicals is worth ₹46.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

While we wouldn't worry about Privi Speciality Chemicals's net debt to EBITDA ratio of 2.9, we think its super-low interest cover of 2.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Privi Speciality Chemicals grew its EBIT by 158% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Privi Speciality Chemicals saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Privi Speciality Chemicals's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Privi Speciality Chemicals is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Privi Speciality Chemicals that you should be aware of before investing here.

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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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.