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. Importantly, Indoco Remedies Limited (NSE:INDOCO) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Indoco Remedies Carry?
You can click the graphic below for the historical numbers, but it shows that Indoco Remedies had ₹2.14b of debt in September 2019, down from ₹2.96b, one year before. However, it also had ₹434.9m in cash, and so its net debt is ₹1.71b.
How Healthy Is Indoco Remedies's Balance Sheet?
We can see from the most recent balance sheet that Indoco Remedies had liabilities of ₹5.14b falling due within a year, and liabilities of ₹1.29b due beyond that. Offsetting this, it had ₹434.9m in cash and ₹2.28b in receivables that were due within 12 months. So it has liabilities totalling ₹3.72b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Indoco Remedies is worth ₹13.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Indoco Remedies has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 2.3. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. We saw Indoco Remedies grow its EBIT by 6.0% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Indoco Remedies can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Indoco Remedies actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While Indoco Remedies's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think Indoco Remedies's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Indoco Remedies insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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