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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Sanginita Chemicals Limited (NSE:SANGINITA) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Sanginita Chemicals's Debt?
As you can see below, Sanginita Chemicals had ₹289.5m of debt at March 2021, down from ₹349.4m a year prior. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Sanginita Chemicals' Balance Sheet?
The latest balance sheet data shows that Sanginita Chemicals had liabilities of ₹305.4m due within a year, and liabilities of ₹2.08m falling due after that. Offsetting this, it had ₹84.0k in cash and ₹291.9m in receivables that were due within 12 months. So its liabilities total ₹15.5m more than the combination of its cash and short-term receivables.
Of course, Sanginita Chemicals has a market capitalization of ₹548.2m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Sanginita Chemicals shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Sanginita Chemicals's EBIT was down 26% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sanginita Chemicals 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. In the last three years, Sanginita Chemicals's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
To be frank both Sanginita Chemicals's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Sanginita Chemicals'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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 5 warning signs we've spotted with Sanginita Chemicals (including 3 which are potentially serious) .
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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