David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Greenlam Industries Limited (NSE:GRNLAMIND) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Greenlam Industries Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Greenlam Industries had ₹2.70b of debt, an increase on ₹2.52b, over one year. However, it also had ₹102.3m in cash, and so its net debt is ₹2.59b.
How Strong Is Greenlam Industries's Balance Sheet?
We can see from the most recent balance sheet that Greenlam Industries had liabilities of ₹3.83b falling due within a year, and liabilities of ₹1.13b due beyond that. On the other hand, it had cash of ₹102.3m and ₹1.95b worth of receivables due within a year. So its liabilities total ₹2.91b more than the combination of its cash and short-term receivables.
Of course, Greenlam Industries has a market capitalization of ₹21.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
With a debt to EBITDA ratio of 1.7, Greenlam Industries uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.1 times interest expense) certainly does not do anything to dispel this impression. The good news is that Greenlam Industries has increased its EBIT by 5.2% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Greenlam Industries's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Greenlam Industries produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On this analysis, Greenlam Industries's conversion of EBIT to free cash flow was a real positive, just like an unsolicited gift of cupcakes from a work colleague. And its apparent ability to to cover its interest expense with its EBIT is also rather rousing! Looking at all the aforementioned factors together, it strikes us that Greenlam Industries can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Over time, share prices tend to follow earnings per share, so if you're interested in Greenlam Industries, you may well want to click here to check an interactive graph of its earnings per share history.
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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