Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 J.K. Cement Limited (NSE:JKCEMENT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does J.K. Cement Carry?
The chart below, which you can click on for greater detail, shows that J.K. Cement had ₹29.8b in debt in March 2019; about the same as the year before. However, it also had ₹7.44b in cash, and so its net debt is ₹22.4b.
A Look At J.K. Cement's Liabilities
We can see from the most recent balance sheet that J.K. Cement had liabilities of ₹16.0b falling due within a year, and liabilities of ₹31.2b due beyond that. Offsetting these obligations, it had cash of ₹7.44b as well as receivables valued at ₹3.39b due within 12 months. So its liabilities total ₹36.4b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since J.K. Cement has a market capitalization of ₹78.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
J.K. Cement's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 3.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Also relevant is that J.K. Cement has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine J.K. Cement'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, J.K. Cement recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
When it comes to the balance sheet, the standout positive for J.K. Cement was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Considering this range of data points, we think J.K. Cement is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you're interested in J.K. Cement, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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