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.' 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. We can see that Prism Johnson Limited (NSE:PRSMJOHNSN) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Prism Johnson's Net Debt?
The chart below, which you can click on for greater detail, shows that Prism Johnson had ₹18.3b in debt in September 2020; about the same as the year before. However, it does have ₹5.79b in cash offsetting this, leading to net debt of about ₹12.5b.
A Look At Prism Johnson's Liabilities
The latest balance sheet data shows that Prism Johnson had liabilities of ₹21.1b due within a year, and liabilities of ₹23.5b falling due after that. Offsetting these obligations, it had cash of ₹5.79b as well as receivables valued at ₹5.73b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹33.1b.
This is a mountain of leverage relative to its market capitalization of ₹50.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Prism Johnson's net debt to EBITDA ratio of 2.6, we think its super-low interest cover of 1.3 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Prism Johnson saw its EBIT tank 30% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Prism Johnson 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. Happily for any shareholders, Prism Johnson actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
To be frank both Prism Johnson'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 converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Prism Johnson's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. For example Prism Johnson has 3 warning signs (and 1 which can't be ignored) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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