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.' 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 can see that Donear Industries Limited (NSE:DONEAR) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Donear Industries Carry?
The chart below, which you can click on for greater detail, shows that Donear Industries had ₹3.02b in debt in March 2019; about the same as the year before. However, it does have ₹145.9m in cash offsetting this, leading to net debt of about ₹2.88b.
How Healthy Is Donear Industries's Balance Sheet?
The latest balance sheet data shows that Donear Industries had liabilities of ₹3.70b due within a year, and liabilities of ₹210.2m falling due after that. Offsetting this, it had ₹145.9m in cash and ₹1.44b in receivables that were due within 12 months. So its liabilities total ₹2.33b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the ₹1.41b 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, Donear Industries would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.0 hit our confidence in Donear Industries like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Donear Industries grew its EBIT at 13% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Donear Industries will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Donear Industries actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
On the face of it, Donear Industries's interest cover 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. After considering the datapoints discussed, we think Donear Industries has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around Donear Industries's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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