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. As with many other companies Murudeshwar Ceramics Limited (NSE:MURUDCERA) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Murudeshwar Ceramics's Net Debt?
As you can see below, Murudeshwar Ceramics had ₹955.9m of debt at March 2019, down from ₹1.04b a year prior. However, it also had ₹30.3m in cash, and so its net debt is ₹925.6m.
How Strong Is Murudeshwar Ceramics's Balance Sheet?
The latest balance sheet data shows that Murudeshwar Ceramics had liabilities of ₹975.1m due within a year, and liabilities of ₹429.3m falling due after that. Offsetting this, it had ₹30.3m in cash and ₹639.2m in receivables that were due within 12 months. So it has liabilities totalling ₹734.9m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's ₹657.0m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Murudeshwar Ceramics's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 1.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Murudeshwar Ceramics's EBIT fell 15% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Murudeshwar Ceramics 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Murudeshwar Ceramics created free cash flow amounting to 2.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, Murudeshwar Ceramics's EBIT growth rate left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Murudeshwar Ceramics has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Murudeshwar Ceramics's earnings per share history for free.
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.