Vadivarhe Speciality Chemicals (NSE:VSCL) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Vadivarhe Speciality Chemicals Limited (NSE:VSCL) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Vadivarhe Speciality Chemicals

What Is Vadivarhe Speciality Chemicals's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Vadivarhe Speciality Chemicals had debt of ₹313.6m, up from ₹250.3m in one year. However, it does have ₹6.62m in cash offsetting this, leading to net debt of about ₹307.0m.

A Look At Vadivarhe Speciality Chemicals' Liabilities

We can see from the most recent balance sheet that Vadivarhe Speciality Chemicals had liabilities of ₹148.1m falling due within a year, and liabilities of ₹229.5m due beyond that. Offsetting these obligations, it had cash of ₹6.62m as well as receivables valued at ₹42.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹328.8m.

While this might seem like a lot, it is not so bad since Vadivarhe Speciality Chemicals has a market capitalization of ₹632.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Vadivarhe Speciality Chemicals shareholders face the double whammy of a high net debt to EBITDA ratio (9.2), and fairly weak interest coverage, since EBIT is just 1.4 times the interest expense. The debt burden here is substantial. One redeeming factor for Vadivarhe Speciality Chemicals is that it turned last year's EBIT loss into a gain of ₹16m, over the last twelve months. 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 Vadivarhe Speciality Chemicals 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Vadivarhe Speciality Chemicals saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Vadivarhe Speciality Chemicals's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Vadivarhe Speciality Chemicals's balance sheet is really quite a risk to the business. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Vadivarhe Speciality Chemicals (2 are significant!) that you should be aware of before investing here.

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.