Is Sumit Woods (NSE:SUMIT) A Risky Investment?

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 Sumit Woods Limited (NSE:SUMIT) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Sumit Woods

What Is Sumit Woods's Debt?

You can click the graphic below for the historical numbers, but it shows that Sumit Woods had ₹1.19b of debt in March 2024, down from ₹1.38b, one year before. On the flip side, it has ₹40.8m in cash leading to net debt of about ₹1.15b.

How Strong Is Sumit Woods' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sumit Woods had liabilities of ₹804.8m due within 12 months and liabilities of ₹1.04b due beyond that. Offsetting this, it had ₹40.8m in cash and ₹559.9m in receivables that were due within 12 months. So it has liabilities totalling ₹1.24b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Sumit Woods is worth ₹4.22b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Sumit Woods's net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 1.8 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On the other hand, Sumit Woods grew its EBIT by 22% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sumit Woods's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Sumit Woods 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

Both Sumit Woods's conversion of EBIT to free cash flow and its interest cover were discouraging. But on the brighter side of life, its EBIT growth rate leaves us feeling more frolicsome. When we consider all the factors discussed, it seems to us that Sumit Woods is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Sumit Woods (of which 1 is a bit concerning!) you should know about.

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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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.