Here's Why Adani Transmission (NSE:ADANITRANS) Has A Meaningful Debt Burden

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.' 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. As with many other companies Adani Transmission Limited (NSE:ADANITRANS) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Adani Transmission

What Is Adani Transmission's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Adani Transmission had debt of ₹256.3b, up from ₹242.5b in one year. However, it also had ₹28.6b in cash, and so its net debt is ₹227.7b.

A Look At Adani Transmission's Liabilities

We can see from the most recent balance sheet that Adani Transmission had liabilities of ₹64.2b falling due within a year, and liabilities of ₹267.9b due beyond that. Offsetting these obligations, it had cash of ₹28.6b as well as receivables valued at ₹10.4b due within 12 months. So its liabilities total ₹293.1b more than the combination of its cash and short-term receivables.

Adani Transmission has a very large market capitalization of ₹1.29t, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Adani Transmission shareholders face the double whammy of a high net debt to EBITDA ratio (5.8), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, Adani Transmission saw its EBIT tank 21% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Adani Transmission 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Adani Transmission generated free cash flow amounting to a very robust 100% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Neither Adani Transmission's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We should also note that Electric Utilities industry companies like Adani Transmission commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Adani Transmission is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 2 warning signs with Adani Transmission (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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. 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.
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