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.' 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. We can see that Solex Energy Limited (NSE:SOLEX) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Solex Energy
What Is Solex Energy's Debt?
The image below, which you can click on for greater detail, shows that at March 2021 Solex Energy had debt of ₹112.3m, up from ₹50.9m in one year. However, it also had ₹20.7m in cash, and so its net debt is ₹91.6m.
A Look At Solex Energy's Liabilities
According to the last reported balance sheet, Solex Energy had liabilities of ₹447.4m due within 12 months, and liabilities of ₹74.8m due beyond 12 months. Offsetting these obligations, it had cash of ₹20.7m as well as receivables valued at ₹610.9m due within 12 months. So it can boast ₹109.4m more liquid assets than total liabilities.
This excess liquidity suggests that Solex Energy is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
Solex Energy's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Solex Energy's EBIT fell a jaw-dropping 53% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Solex Energy'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Solex Energy recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
Based on what we've seen Solex Energy is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its level of total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Solex Energy's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should learn about the 6 warning signs we've spotted with Solex Energy (including 2 which are significant) .
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.
When trading Solex Energy or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
New: Manage All Your Stock Portfolios in One Place
We've created the ultimate portfolio companion for stock investors, and it's free.
• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks
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. 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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
About NSEI:SOLEX
Proven track record with mediocre balance sheet.
