Health Check: How Prudently Does Vadivarhe Speciality Chemicals (NSE:VSCL) Use Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Vadivarhe Speciality Chemicals Limited (NSE:VSCL) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Vadivarhe Speciality Chemicals

How Much Debt Does Vadivarhe Speciality Chemicals Carry?

You can click the graphic below for the historical numbers, but it shows that Vadivarhe Speciality Chemicals had ₹195.8m of debt in September 2020, down from ₹214.9m, one year before. However, it also had ₹7.26m in cash, and so its net debt is ₹188.6m.

A Look At Vadivarhe Speciality Chemicals's Liabilities

We can see from the most recent balance sheet that Vadivarhe Speciality Chemicals had liabilities of ₹188.5m falling due within a year, and liabilities of ₹106.1m due beyond that. Offsetting this, it had ₹7.26m in cash and ₹116.0m in receivables that were due within 12 months. So its liabilities total ₹171.3m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of ₹189.2m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But it is Vadivarhe Speciality Chemicals'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.

Over 12 months, Vadivarhe Speciality Chemicals made a loss at the EBIT level, and saw its revenue drop to ₹260m, which is a fall of 26%. That makes us nervous, to say the least.

Caveat Emptor

While Vadivarhe Speciality Chemicals's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable ₹62m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of ₹51m into a profit. In the meantime, we consider the stock very risky. 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 Vadivarhe Speciality Chemicals you should be aware of, and 3 of them are concerning.

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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