Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Jaiprakash Power Ventures Limited (NSE:JPPOWER) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Jaiprakash Power Ventures's Debt?
The image below, which you can click on for greater detail, shows that Jaiprakash Power Ventures had debt of ₹55.7b at the end of September 2020, a reduction from ₹191.4b over a year. However, it also had ₹3.43b in cash, and so its net debt is ₹52.3b.
How Strong Is Jaiprakash Power Ventures' Balance Sheet?
The latest balance sheet data shows that Jaiprakash Power Ventures had liabilities of ₹21.0b due within a year, and liabilities of ₹54.6b falling due after that. Offsetting these obligations, it had cash of ₹3.43b as well as receivables valued at ₹6.11b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹66.1b.
This deficit casts a shadow over the ₹19.5b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Jaiprakash Power Ventures would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
While Jaiprakash Power Ventures's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 1.3, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Jaiprakash Power Ventures grew its EBIT a smooth 79% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Jaiprakash Power Ventures 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, Jaiprakash Power Ventures actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While Jaiprakash Power Ventures's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Taking the abovementioned factors together we do think Jaiprakash Power Ventures's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Jaiprakash Power Ventures (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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