Here's Why Southern Petrochemical Industries (NSE:SPIC) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Southern Petrochemical Industries Corporation Limited (NSE:SPIC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Southern Petrochemical Industries

What Is Southern Petrochemical Industries's Net Debt?

As you can see below, Southern Petrochemical Industries had ₹1.04b of debt at September 2021, down from ₹1.85b a year prior. But on the other hand it also has ₹1.15b in cash, leading to a ₹110.4m net cash position.

A Look At Southern Petrochemical Industries' Liabilities

The latest balance sheet data shows that Southern Petrochemical Industries had liabilities of ₹14.8b due within a year, and liabilities of ₹319.9m falling due after that. On the other hand, it had cash of ₹1.15b and ₹259.5m worth of receivables due within a year. So it has liabilities totalling ₹13.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₹11.4b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Southern Petrochemical Industries has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

In addition to that, we're happy to report that Southern Petrochemical Industries has boosted its EBIT by 73%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Southern Petrochemical Industries will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Southern Petrochemical Industries may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Southern Petrochemical Industries reported free cash flow worth 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While Southern Petrochemical Industries does have more liabilities than liquid assets, it also has net cash of ₹110.4m. And it impressed us with its EBIT growth of 73% over the last year. So we are not troubled with Southern Petrochemical Industries's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Southern Petrochemical Industries you should know about.

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.