We Think Gujarat Industries Power (NSE:GIPCL) Is Taking Some Risk With Its 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 can see that Gujarat Industries Power Company Limited (NSE:GIPCL) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Gujarat Industries Power

What Is Gujarat Industries Power's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Gujarat Industries Power had debt of ₹4.86b, up from ₹3.89b in one year. However, it also had ₹1.52b in cash, and so its net debt is ₹3.34b.

A Look At Gujarat Industries Power's Liabilities

The latest balance sheet data shows that Gujarat Industries Power had liabilities of ₹5.58b due within a year, and liabilities of ₹6.68b falling due after that. On the other hand, it had cash of ₹1.52b and ₹2.89b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹7.85b.

This deficit is considerable relative to its market capitalization of ₹11.6b, so it does suggest shareholders should keep an eye on Gujarat Industries Power's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

Gujarat Industries Power has a low net debt to EBITDA ratio of only 0.85. And its EBIT covers its interest expense a whopping 54.4 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Gujarat Industries Power has seen its EBIT plunge 11% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Gujarat Industries Power 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Gujarat Industries Power recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Gujarat Industries Power's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Gujarat Industries Power is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 1 warning sign with Gujarat Industries Power , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.