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 Hindustan Composites Limited (NSE:HINDCOMPOS) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hindustan Composites's Net Debt?
The image below, which you can click on for greater detail, shows that Hindustan Composites had debt of ₹26.8m at the end of March 2019, a reduction from ₹49.4m over a year. But on the other hand it also has ₹389.5m in cash, leading to a ₹362.7m net cash position.
How Healthy Is Hindustan Composites's Balance Sheet?
The latest balance sheet data shows that Hindustan Composites had liabilities of ₹411.7m due within a year, and liabilities of ₹517.9m falling due after that. Offsetting this, it had ₹389.5m in cash and ₹763.8m in receivables that were due within 12 months. So it actually has ₹223.7m more liquid assets than total liabilities.
This surplus suggests that Hindustan Composites has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Hindustan Composites has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Hindustan Composites if management cannot prevent a repeat of the 41% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hindustan Composites'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. Hindustan Composites may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Hindustan Composites actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While we empathize with investors who find debt concerning, you should keep in mind that Hindustan Composites has net cash of ₹363m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of ₹433m, being 110% of its EBIT. So we don't have any problem with Hindustan Composites's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Hindustan Composites, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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