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.' 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 note that Wipro Limited (NSE:WIPRO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. 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. 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.
What Is Wipro's Debt?
The image below, which you can click on for greater detail, shows that at December 2021 Wipro had debt of ₹133.9b, up from ₹73.5b in one year. But it also has ₹342.6b in cash to offset that, meaning it has ₹208.6b net cash.
A Look At Wipro's Liabilities
Zooming in on the latest balance sheet data, we can see that Wipro had liabilities of ₹251.1b due within 12 months and liabilities of ₹111.9b due beyond that. Offsetting these obligations, it had cash of ₹342.6b as well as receivables valued at ₹189.9b due within 12 months. So it actually has ₹169.4b more liquid assets than total liabilities.
This short term liquidity is a sign that Wipro could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Wipro has more cash than debt is arguably a good indication that it can manage its debt safely.
Also positive, Wipro grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Wipro 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Wipro may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Wipro generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company's debt, in this case Wipro has ₹208.6b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 85% of that EBIT to free cash flow, bringing in ₹83b. So we don't think Wipro's use of debt is risky. 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. For instance, we've identified 2 warning signs for Wipro that 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.
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.