Sarda Energy & Minerals (NSE:SARDAEN) Has A Somewhat Strained Balance Sheet

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. As with many other companies Sarda Energy & Minerals Limited (NSE:SARDAEN) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sarda Energy & Minerals

What Is Sarda Energy & Minerals's Net Debt?

As you can see below, at the end of September 2020, Sarda Energy & Minerals had ₹15.4b of debt, up from ₹14.5b a year ago. Click the image for more detail. On the flip side, it has ₹2.92b in cash leading to net debt of about ₹12.5b.

How Healthy Is Sarda Energy & Minerals' Balance Sheet?

The latest balance sheet data shows that Sarda Energy & Minerals had liabilities of ₹5.51b due within a year, and liabilities of ₹15.2b falling due after that. On the other hand, it had cash of ₹2.92b and ₹4.31b worth of receivables due within a year. So it has liabilities totalling ₹13.5b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of ₹12.4b, we think shareholders really should watch Sarda Energy & Minerals's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

Sarda Energy & Minerals's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 5.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Sarda Energy & Minerals's EBIT fell a jaw-dropping 22% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sarda Energy & Minerals's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Sarda Energy & Minerals actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

We'd go so far as to say Sarda Energy & Minerals's EBIT growth rate was disappointing. But at least its interest cover is not so bad. After considering the datapoints discussed, we think Sarda Energy & Minerals has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Case in point: We've spotted 4 warning signs for Sarda Energy & Minerals you should be aware of, and 1 of them doesn't sit too well with us.

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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