Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, The Bombay Dyeing and Manufacturing Company Limited (NSE:BOMDYEING) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Bombay Dyeing and Manufacturing's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Bombay Dyeing and Manufacturing had debt of ₹39.7b, up from ₹28.0b in one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Bombay Dyeing and Manufacturing's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Bombay Dyeing and Manufacturing had liabilities of ₹16.0b due within 12 months and liabilities of ₹34.0b due beyond that. Offsetting these obligations, it had cash of ₹362.7m as well as receivables valued at ₹10.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹38.7b.
This deficit casts a shadow over the ₹17.9b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Bombay Dyeing and Manufacturing would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Bombay Dyeing and Manufacturing has net debt worth 2.1 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.0 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Pleasingly, Bombay Dyeing and Manufacturing is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 120% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Bombay Dyeing and Manufacturing 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Bombay Dyeing and Manufacturing burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Bombay Dyeing and Manufacturing's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Bombay Dyeing and Manufacturing'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. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.