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 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 Atul Ltd (NSE:ATUL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Atul's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Atul had ₹546.7m of debt, an increase on ₹159.2m, over one year. But on the other hand it also has ₹2.63b in cash, leading to a ₹2.09b net cash position.
How Healthy Is Atul's Balance Sheet?
We can see from the most recent balance sheet that Atul had liabilities of ₹5.77b falling due within a year, and liabilities of ₹2.37b due beyond that. Offsetting this, it had ₹2.63b in cash and ₹8.49b in receivables that were due within 12 months. So it can boast ₹2.98b more liquid assets than total liabilities.
This short term liquidity is a sign that Atul could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Atul has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Atul has boosted its EBIT by 60%, thus reducing the spectre of future debt repayments. 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 Atul'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Atul may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Atul's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Atul has net cash of ₹2.1b, as well as more liquid assets than liabilities. And we liked the look of last year's 60% year-on-year EBIT growth. So we don't think Atul's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Atul's earnings per share history for free.
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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