Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Godrej Properties Limited (NSE:GODREJPROP) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Godrej Properties's Debt?
As you can see below, at the end of September 2022, Godrej Properties had ₹53.6b of debt, up from ₹47.7b a year ago. Click the image for more detail. On the flip side, it has ₹39.8b in cash leading to net debt of about ₹13.8b.
A Look At Godrej Properties' Liabilities
We can see from the most recent balance sheet that Godrej Properties had liabilities of ₹102.3b falling due within a year, and liabilities of ₹340.4m due beyond that. Offsetting these obligations, it had cash of ₹39.8b as well as receivables valued at ₹30.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹32.7b.
Of course, Godrej Properties has a market capitalization of ₹361.6b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
As it happens Godrej Properties has a fairly concerning net debt to EBITDA ratio of 8.3 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! We also note that Godrej Properties improved its EBIT from a last year's loss to a positive ₹1.5b. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Godrej Properties can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Godrej Properties burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither Godrej Properties's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Godrej Properties's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should be aware of the 1 warning sign we've spotted with Godrej Properties .
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.