These 4 Measures Indicate That Shemaroo Entertainment (NSE:SHEMAROO) Is Using Debt In A Risky Way

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Shemaroo Entertainment Limited (NSE:SHEMAROO) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shemaroo Entertainment

What Is Shemaroo Entertainment's Debt?

As you can see below, at the end of September 2020, Shemaroo Entertainment had ₹2.68b of debt, up from ₹2.32b a year ago. Click the image for more detail. However, it also had ₹62.8m in cash, and so its net debt is ₹2.62b.

How Healthy Is Shemaroo Entertainment's Balance Sheet?

According to the last reported balance sheet, Shemaroo Entertainment had liabilities of ₹3.25b due within 12 months, and liabilities of ₹254.3m due beyond 12 months. Offsetting these obligations, it had cash of ₹62.8m as well as receivables valued at ₹1.10b due within 12 months. So it has liabilities totalling ₹2.34b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₹1.48b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Shemaroo Entertainment would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.12 times and a disturbingly high net debt to EBITDA ratio of 27.8 hit our confidence in Shemaroo Entertainment like a one-two punch to the gut. The debt burden here is substantial. Worse, Shemaroo Entertainment's EBIT was down 98% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shemaroo Entertainment's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Shemaroo Entertainment created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Shemaroo Entertainment'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 Shemaroo Entertainment 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Shemaroo Entertainment (1 doesn't sit too well with us) you should be aware of.

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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