Is Gujarat State Petronet (NSE:GSPL) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Gujarat State Petronet Limited (NSE:GSPL) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Gujarat State Petronet

What Is Gujarat State Petronet's Debt?

The image below, which you can click on for greater detail, shows that Gujarat State Petronet had debt of ₹19.7b at the end of September 2020, a reduction from ₹33.8b over a year. However, it does have ₹11.7b in cash offsetting this, leading to net debt of about ₹8.06b.

How Healthy Is Gujarat State Petronet's Balance Sheet?

The latest balance sheet data shows that Gujarat State Petronet had liabilities of ₹33.1b due within a year, and liabilities of ₹33.1b falling due after that. Offsetting this, it had ₹11.7b in cash and ₹6.82b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹47.7b.

This deficit isn't so bad because Gujarat State Petronet is worth ₹124.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Gujarat State Petronet has a low net debt to EBITDA ratio of only 0.25. And its EBIT easily covers its interest expense, being 13.1 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Gujarat State Petronet grew its EBIT by 9.5% in the last year, making that debt load look even more manageable. 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 Gujarat State Petronet can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Gujarat State Petronet recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Gujarat State Petronet's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. We would also note that Gas Utilities industry companies like Gujarat State Petronet commonly do use debt without problems. Zooming out, Gujarat State Petronet seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Gujarat State Petronet that you should be aware of.

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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