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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. We note that Eros International Media Limited (NSE:EROSMEDIA) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Eros International Media’s Debt?
As you can see below, Eros International Media had ₹5.98b of debt at March 2019, down from ₹7.48b a year prior. However, because it has a cash reserve of ₹1.51b, its net debt is less, at about ₹4.47b.
How Strong Is Eros International Media’s Balance Sheet?
According to the last reported balance sheet, Eros International Media had liabilities of ₹12.5b due within 12 months, and liabilities of ₹3.73b due beyond 12 months. Offsetting this, it had ₹1.51b in cash and ₹8.12b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹6.60b.
This deficit casts a shadow over the ₹1.50b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Eros International Media would probably need a major re-capitalization if its creditors were to demand repayment. Because it carries more debt than cash, we think it’s worth watching Eros International Media’s balance sheet over time.
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).
Eros International Media’s net debt is sitting at a very reasonable 1.50 times its EBITDA, while its EBIT covered its interest expense just 3.70 times last year. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Eros International Media’s EBIT flopped 14% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Eros International Media 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, 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. Over the last three years, Eros International Media 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.
To be frank both Eros International Media’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability handle its debt, based on its EBITDA, isn’t such a worry. Taking into account all the aforementioned factors, it looks like Eros International Media has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Given our concerns about Eros International Media’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.