Is Southern Petrochemical Industries (NSE:SPIC) Using Too Much Debt?

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 Southern Petrochemical Industries Corporation Limited (NSE:SPIC) makes use of debt. But the more important question is: how much risk is that debt creating?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Southern Petrochemical Industries

What Is Southern Petrochemical Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 Southern Petrochemical Industries had ₹4.23b of debt, an increase on ₹4.00b, over one year. However, it does have ₹11.8b in cash offsetting this, leading to net cash of ₹7.52b.

How Strong Is Southern Petrochemical Industries's Balance Sheet?

The latest balance sheet data shows that Southern Petrochemical Industries had liabilities of ₹16.3b due within a year, and liabilities of ₹301.3m falling due after that. Offsetting this, it had ₹11.8b in cash and ₹89.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹4.7b.

When you consider that this deficiency exceeds the company's ₹4.29b 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.

If Southern Petrochemical Industries can keep growing EBIT at last year's rate of 18% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Southern Petrochemical 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. 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. Happily for any shareholders, Southern Petrochemical Industries actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Southern Petrochemical Industries does have more liabilities than liquid assets, it also has net cash of ₹7.52b. And it impressed us with free cash flow of -₹118.1m, being 122% of its EBIT. So we are not troubled with Southern Petrochemical Industries's debt use. 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. Be aware that Southern Petrochemical Industries is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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