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.' 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 Sagar Cements Limited (NSE:SAGCEM) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Sagar Cements's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Sagar Cements had debt of ₹9.19b, up from ₹8.19b in one year. On the flip side, it has ₹1.33b in cash leading to net debt of about ₹7.86b.
How Healthy Is Sagar Cements' Balance Sheet?
The latest balance sheet data shows that Sagar Cements had liabilities of ₹5.93b due within a year, and liabilities of ₹8.74b falling due after that. Offsetting these obligations, it had cash of ₹1.33b as well as receivables valued at ₹1.69b due within 12 months. So its liabilities total ₹11.6b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Sagar Cements has a market capitalization of ₹26.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
Sagar Cements has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.2 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Sadly, Sagar Cements's EBIT actually dropped 9.2% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sagar Cements's ability to maintain a healthy balance sheet going forward. 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. Over the last three years, Sagar Cements saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Sagar Cements's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its interest cover is not so bad. Looking at the bigger picture, it seems clear to us that Sagar Cements's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Sagar Cements that you should be aware of before investing here.
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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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.