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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.’ 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 can see that Usha Martin Limited (NSE:USHAMART) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 examine debt levels, we first consider both cash and debt levels, together.
What Is Usha Martin’s Net Debt?
As you can see below, Usha Martin had ₹31.6b of debt at March 2019, down from ₹40.7b a year prior. However, it does have ₹1.81b in cash offsetting this, leading to net debt of about ₹29.8b.
A Look At Usha Martin’s Liabilities
The latest balance sheet data shows that Usha Martin had liabilities of ₹38.3b due within a year, and liabilities of ₹23.7b falling due after that. Offsetting this, it had ₹1.81b in cash and ₹3.34b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹56.8b.
This deficit casts a shadow over the ₹8.64b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Usha Martin would likely require a major re-capitalisation if it had to pay its creditors today. Because it carries more debt than cash, we think it’s worth watching Usha Martin’s balance sheet over time.
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.
Weak interest cover of 2.07 times and a disturbingly high net debt to EBITDA ratio of 5.60 hit our confidence in Usha Martin like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Investors should also be troubled by the fact that Usha Martin saw its EBIT drop by 11% over the last twelve months. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Usha Martin 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Usha Martin actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Usha Martin’s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. We’re quite clear that we consider Usha Martin to be really rather risky, as a result of its debt. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. Over time, share prices tend to follow earnings per share, so if you’re interested in Usha Martin, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.