Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Sanghi Industries Limited (NSE:SANGHIIND) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Sanghi Industries's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 Sanghi Industries had debt of ₹11.7b, up from ₹11.2b in one year. On the flip side, it has ₹594.4m in cash leading to net debt of about ₹11.1b.
How Healthy Is Sanghi Industries' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sanghi Industries had liabilities of ₹8.01b due within 12 months and liabilities of ₹10.3b due beyond that. Offsetting this, it had ₹594.4m in cash and ₹390.4m in receivables that were due within 12 months. So it has liabilities totalling ₹17.3b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the ₹10.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Sanghi Industries would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 5.8 hit our confidence in Sanghi Industries like a one-two punch to the gut. The debt burden here is substantial. The good news is that Sanghi Industries improved its EBIT by 2.2% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sanghi Industries will need earnings to service that debt. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Sanghi Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Sanghi Industries's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Sanghi Industries has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 3 warning signs for Sanghi Industries (2 don't sit too well with us!) that you should be aware of before investing here.
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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