Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that AGC Networks Limited (NSE:AGCNET) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 AGC Networks's Debt?
As you can see below, at the end of March 2019, AGC Networks had ₹7.89b of debt, up from ₹1.39b a year ago. Click the image for more detail. However, it also had ₹3.29b in cash, and so its net debt is ₹4.60b.
How Healthy Is AGC Networks's Balance Sheet?
We can see from the most recent balance sheet that AGC Networks had liabilities of ₹16.3b falling due within a year, and liabilities of ₹7.84b due beyond that. On the other hand, it had cash of ₹3.29b and ₹8.96b worth of receivables due within a year. So its liabilities total ₹11.9b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₹3.42b 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, AGC Networks would probably need a major re-capitalization if its creditors were to demand repayment.
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).
While we wouldn't worry about AGC Networks's net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 1.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that AGC Networks actually grew its EBIT by a hefty 104%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But it is AGC Networks's earnings that will influence how the balance sheet holds up in the future. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, AGC Networks burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both AGC Networks's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that AGC Networks's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While AGC Networks didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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