Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Adani Total Gas Limited (NSE:ATGL) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Adani Total Gas
What Is Adani Total Gas's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2022 Adani Total Gas had debt of ₹12.0b, up from ₹6.74b in one year. However, because it has a cash reserve of ₹3.98b, its net debt is less, at about ₹8.06b.
A Look At Adani Total Gas' Liabilities
The latest balance sheet data shows that Adani Total Gas had liabilities of ₹17.6b due within a year, and liabilities of ₹6.31b falling due after that. On the other hand, it had cash of ₹3.98b and ₹2.37b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹17.5b.
Having regard to Adani Total Gas' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the ₹1.00t company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Adani Total Gas 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Adani Total Gas's net debt is only 1.0 times its EBITDA. And its EBIT covers its interest expense a whopping 24.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Adani Total Gas saw its EBIT drop by 8.8% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. 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.
Finally, while the tax-man may adore accounting profits, lenders only accept 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 last three years, Adani Total Gas recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
When it comes to the balance sheet, the standout positive for Adani Total Gas was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. We would also note that Gas Utilities industry companies like Adani Total Gas commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Adani Total Gas's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 2 warning signs for Adani Total Gas you should be aware of, and 1 of them doesn't sit too well with us.
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.
About NSEI:ATGL
Solid track record with mediocre balance sheet.
