Here's Why Punjab Chemicals and Crop Protection (NSE:PUNJABCHEM) Can Manage Its Debt Responsibly

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. Importantly, Punjab Chemicals and Crop Protection Limited (NSE:PUNJABCHEM) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Punjab Chemicals and Crop Protection

How Much Debt Does Punjab Chemicals and Crop Protection Carry?

The image below, which you can click on for greater detail, shows that at September 2022 Punjab Chemicals and Crop Protection had debt of ₹1.06b, up from ₹889.0m in one year. On the flip side, it has ₹151.5m in cash leading to net debt of about ₹907.2m.

A Look At Punjab Chemicals and Crop Protection's Liabilities

We can see from the most recent balance sheet that Punjab Chemicals and Crop Protection had liabilities of ₹2.57b falling due within a year, and liabilities of ₹926.5m due beyond that. Offsetting these obligations, it had cash of ₹151.5m as well as receivables valued at ₹1.44b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.90b.

Given Punjab Chemicals and Crop Protection has a market capitalization of ₹12.1b, 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). 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).

With net debt sitting at just 0.68 times EBITDA, Punjab Chemicals and Crop Protection is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.8 times the interest expense over the last year. Fortunately, Punjab Chemicals and Crop Protection grew its EBIT by 3.2% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Punjab Chemicals and Crop Protection's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, Punjab Chemicals and Crop Protection barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

Punjab Chemicals and Crop Protection's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Punjab Chemicals and Crop Protection's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Punjab Chemicals and Crop Protection, you may well want to click here to check an interactive graph of its earnings per share history.

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.