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 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. Importantly, Gujarat State Fertilizers & Chemicals Limited (NSE:GSFC) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Gujarat State Fertilizers & Chemicals's Net Debt?
As you can see below, at the end of September 2019, Gujarat State Fertilizers & Chemicals had ₹15.1b of debt, up from ₹10.7b a year ago. Click the image for more detail. On the flip side, it has ₹1.76b in cash leading to net debt of about ₹13.3b.
A Look At Gujarat State Fertilizers & Chemicals's Liabilities
According to the last reported balance sheet, Gujarat State Fertilizers & Chemicals had liabilities of ₹28.1b due within 12 months, and liabilities of ₹6.30b due beyond 12 months. Offsetting this, it had ₹1.76b in cash and ₹29.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹3.36b.
Given Gujarat State Fertilizers & Chemicals has a market capitalization of ₹30.1b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
We'd say that Gujarat State Fertilizers & Chemicals's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its commanding EBIT of 48.5 times its interest expense, implies the debt load is as light as a peacock feather. Shareholders should be aware that Gujarat State Fertilizers & Chemicals's EBIT was down 23% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Gujarat State Fertilizers & Chemicals's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Gujarat State Fertilizers & Chemicals created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Gujarat State Fertilizers & Chemicals's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Gujarat State Fertilizers & Chemicals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Over time, share prices tend to follow earnings per share, so if you're interested in Gujarat State Fertilizers & Chemicals, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.