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.' 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. As with many other companies Sumit Woods Limited (NSE:SUMIT) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
How Much Debt Does Sumit Woods Carry?
The image below, which you can click on for greater detail, shows that at March 2021 Sumit Woods had debt of ₹643.3m, up from ₹503.2m in one year. However, it also had ₹88.1m in cash, and so its net debt is ₹555.2m.
A Look At Sumit Woods' Liabilities
The latest balance sheet data shows that Sumit Woods had liabilities of ₹307.6m due within a year, and liabilities of ₹648.6m falling due after that. Offsetting these obligations, it had cash of ₹88.1m as well as receivables valued at ₹229.9m due within 12 months. So its liabilities total ₹638.2m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of ₹506.2m, we think shareholders really should watch Sumit Woods's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Sumit Woods made a loss at the EBIT level, and saw its revenue drop to ₹470m, which is a fall of 3.4%. We would much prefer see growth.
Importantly, Sumit Woods had an earnings before interest and tax (EBIT) loss over the last year. Its EBIT loss was a whopping ₹128m. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through ₹16m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Sumit Woods (including 3 which don't sit too well with us) .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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