Here's Why Adani Total Gas (NSE:ATGL) Can Manage Its Debt Responsibly

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. Importantly, Adani Total Gas Limited (NSE:ATGL) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Adani Total Gas

What Is Adani Total Gas's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Adani Total Gas had debt of ₹3.73b, up from ₹3.46b in one year. On the flip side, it has ₹767.9m in cash leading to net debt of about ₹2.96b.

A Look At Adani Total Gas' Liabilities

According to the last reported balance sheet, Adani Total Gas had liabilities of ₹6.27b due within 12 months, and liabilities of ₹4.71b due beyond 12 months. On the other hand, it had cash of ₹767.9m and ₹1.02b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹9.19b.

Of course, Adani Total Gas has a market capitalization of ₹418.0b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Adani Total Gas has a very light debt load indeed.

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

Adani Total Gas has a low net debt to EBITDA ratio of only 0.49. And its EBIT easily covers its interest expense, being 108 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Adani Total Gas 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 you can't view debt in total isolation; since Adani Total Gas 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Adani Total Gas recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Adani Total Gas's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. We would also note that Gas Utilities industry companies like Adani Total Gas commonly do use debt without problems. Looking at the bigger picture, we think Adani Total Gas's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Adani Total Gas has 2 warning signs (and 1 which is significant) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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