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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Power Grid Corporation of India Limited (NSE:POWERGRID) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Power Grid Corporation of India's Net Debt?
As you can see below, Power Grid Corporation of India had ₹1.40t of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had ₹134.0b in cash, and so its net debt is ₹1.27t.
How Strong Is Power Grid Corporation of India's Balance Sheet?
The latest balance sheet data shows that Power Grid Corporation of India had liabilities of ₹315.0b due within a year, and liabilities of ₹1.59t falling due after that. On the other hand, it had cash of ₹134.0b and ₹65.8b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.71t.
This deficit casts a shadow over the ₹1.01t company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Power Grid Corporation of India would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Power Grid Corporation of India's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, Power Grid Corporation of India grew its EBIT by 4.1% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Power Grid Corporation of India 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Power Grid Corporation of India's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say Power Grid Corporation of India's level of total liabilities was disappointing. But at least its EBIT growth rate is not so bad. We should also note that Electric Utilities industry companies like Power Grid Corporation of India commonly do use debt without problems. Overall, it seems to us that Power Grid Corporation of India's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Power Grid Corporation of India has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. 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.
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