Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 CEAT Limited (NSE:CEATLTD) 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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is CEAT's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 CEAT had debt of ₹18.4b, up from ₹9.43b in one year. However, it does have ₹1.07b in cash offsetting this, leading to net debt of about ₹17.4b.
A Look At CEAT's Liabilities
Zooming in on the latest balance sheet data, we can see that CEAT had liabilities of ₹23.8b due within 12 months and liabilities of ₹17.6b due beyond that. On the other hand, it had cash of ₹1.07b and ₹7.42b worth of receivables due within a year. So it has liabilities totalling ₹33.0b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of ₹40.8b, so it does suggest shareholders should keep an eye on CEAT's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
CEAT has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 5.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, CEAT's EBIT fell a jaw-dropping 23% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine CEAT's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CEAT burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, CEAT's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We're quite clear that we consider CEAT to be really rather risky, as a result of its balance sheet health. 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. Over time, share prices tend to follow earnings per share, so if you're interested in CEAT, 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.
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