Warren Buffett famously said, '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 note that Lokesh Machines Limited (NSE:LOKESHMACH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Lokesh Machines's Net Debt?
The image below, which you can click on for greater detail, shows that Lokesh Machines had debt of ₹727.6m at the end of June 2019, a reduction from ₹807.7m over a year. However, it does have ₹52.6m in cash offsetting this, leading to net debt of about ₹674.9m.
How Healthy Is Lokesh Machines's Balance Sheet?
We can see from the most recent balance sheet that Lokesh Machines had liabilities of ₹1.19b falling due within a year, and liabilities of ₹181.7m due beyond that. Offsetting this, it had ₹52.6m in cash and ₹262.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.05b.
This deficit casts a shadow over the ₹636.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Lokesh Machines would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Lokesh Machines has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 1.7. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Lokesh Machines grew its EBIT by 7.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Lokesh Machines 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, 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, Lokesh Machines produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On the face of it, Lokesh Machines'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 at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Lokesh Machines has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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