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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Vikas EcoTech Limited (NSE:VIKASECO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Vikas EcoTech Carry?
As you can see below, at the end of September 2020, Vikas EcoTech had ₹1.63b of debt, up from ₹1.56b a year ago. Click the image for more detail. However, it does have ₹106.3m in cash offsetting this, leading to net debt of about ₹1.52b.
A Look At Vikas EcoTech's Liabilities
The latest balance sheet data shows that Vikas EcoTech had liabilities of ₹2.15b due within a year, and liabilities of ₹81.9m falling due after that. On the other hand, it had cash of ₹106.3m and ₹1.07b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.06b.
Given this deficit is actually higher than the company's market capitalization of ₹710.9m, we think shareholders really should watch Vikas EcoTech'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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.52 times and a disturbingly high net debt to EBITDA ratio of 11.9 hit our confidence in Vikas EcoTech like a one-two punch to the gut. The debt burden here is substantial. Even worse, Vikas EcoTech saw its EBIT tank 71% over the last 12 months. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Vikas EcoTech'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Vikas EcoTech recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Vikas EcoTech's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. Considering all the factors previously mentioned, we think that Vikas EcoTech really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. We've identified 4 warning signs with Vikas EcoTech (at least 3 which are significant) , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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