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.' 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 Kothari Petrochemicals Limited (NSE:KOTHARIPET) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Kothari Petrochemicals's Net Debt?
The image below, which you can click on for greater detail, shows that Kothari Petrochemicals had debt of ₹274.7m at the end of March 2019, a reduction from ₹335.8m over a year. However, it does have ₹54.9m in cash offsetting this, leading to net debt of about ₹219.7m.
How Healthy Is Kothari Petrochemicals's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kothari Petrochemicals had liabilities of ₹510.1m due within 12 months and liabilities of ₹134.0m due beyond that. On the other hand, it had cash of ₹54.9m and ₹223.2m worth of receivables due within a year. So its liabilities total ₹365.9m more than the combination of its cash and short-term receivables.
Kothari Petrochemicals has a market capitalization of ₹1.04b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
With net debt sitting at just 0.92 times EBITDA, Kothari Petrochemicals is arguably pretty conservatively geared. And it boasts interest cover of 8.0 times, which is more than adequate. Another good sign is that Kothari Petrochemicals has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kothari Petrochemicals's earnings that will influence how the balance sheet holds up in the future. 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 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, Kothari Petrochemicals 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.
Based on what we've seen Kothari Petrochemicals is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Kothari Petrochemicals's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in Kothari Petrochemicals, you may well want to click here to check an interactive graph of its earnings per share history.
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.