Stock Analysis

We Think Adani Power (NSE:ADANIPOWER) Can Stay On Top Of Its Debt

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NSEI:ADANIPOWER
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Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Adani Power Limited (NSE:ADANIPOWER) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Adani Power's Debt?

You can click the graphic below for the historical numbers, but it shows that Adani Power had ₹489.0b of debt in March 2022, down from ₹525.4b, one year before. And it doesn't have much cash, so its net debt is about the same.

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NSEI:ADANIPOWER Debt to Equity History August 7th 2022

How Strong Is Adani Power's Balance Sheet?

The latest balance sheet data shows that Adani Power had liabilities of ₹171.4b due within a year, and liabilities of ₹461.3b falling due after that. Offsetting these obligations, it had cash of ₹9.70b as well as receivables valued at ₹96.3b due within 12 months. So its liabilities total ₹526.8b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Adani Power is worth a massive ₹1.28t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Adani Power's net debt is 3.5 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Adani Power grew its EBIT by 87% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Adani Power's earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Adani Power recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Adani Power's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. When we consider the range of factors above, it looks like Adani Power is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Adani Power you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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