Is Kernex Microsystems (India) (NSE:KERNEX) Using Too Much Debt?

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. We note that Kernex Microsystems (India) Limited (NSE:KERNEX) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Kernex Microsystems (India)

How Much Debt Does Kernex Microsystems (India) Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Kernex Microsystems (India) had debt of ₹318.6m, up from ₹212.5m in one year. However, because it has a cash reserve of ₹241.5m, its net debt is less, at about ₹77.1m.

How Strong Is Kernex Microsystems (India)'s Balance Sheet?

According to the last reported balance sheet, Kernex Microsystems (India) had liabilities of ₹737.4m due within 12 months, and liabilities of ₹16.6m due beyond 12 months. On the other hand, it had cash of ₹241.5m and ₹238.3m worth of receivables due within a year. So it has liabilities totalling ₹274.3m more than its cash and near-term receivables, combined.

Given Kernex Microsystems (India) has a market capitalization of ₹11.9b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Kernex Microsystems (India) has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Kernex Microsystems (India) has a very low debt to EBITDA ratio of 0.59 so it is strange to see weak interest coverage, with last year's EBIT being only 1.5 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Kernex Microsystems (India) made a loss at the EBIT level, last year, but improved that to positive EBIT of ₹63m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kernex Microsystems (India) will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Kernex Microsystems (India) saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Kernex Microsystems (India)'s interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Kernex Microsystems (India)'s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Kernex Microsystems (India) that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.