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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Mangalore Refinery and Petrochemicals Limited (NSE:MRPL) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Mangalore Refinery and Petrochemicals's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Mangalore Refinery and Petrochemicals had debt of ₹156.2b, up from ₹149.2b in one year. And it doesn't have much cash, so its net debt is about the same.
A Look At Mangalore Refinery and Petrochemicals's Liabilities
According to the last reported balance sheet, Mangalore Refinery and Petrochemicals had liabilities of ₹179.1b due within 12 months, and liabilities of ₹46.1b due beyond 12 months. Offsetting this, it had ₹46.7m in cash and ₹23.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹201.3b.
This deficit casts a shadow over the ₹85.9b 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, Mangalore Refinery and Petrochemicals 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 0.34 times and a disturbingly high net debt to EBITDA ratio of 12.1 hit our confidence in Mangalore Refinery and Petrochemicals like a one-two punch to the gut. The debt burden here is substantial. Even worse, Mangalore Refinery and Petrochemicals saw its EBIT tank 93% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Mangalore Refinery and Petrochemicals can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Mangalore Refinery and Petrochemicals recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
On the face of it, Mangalore Refinery and Petrochemicals's EBIT growth rate 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. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Mangalore Refinery and Petrochemicals really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Even though Mangalore Refinery and Petrochemicals lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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