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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Kennametal India Limited (NSE:KENNAMET) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Kennametal India's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Kennametal India had ₹100.0m of debt, an increase on none, over one year. However, it does have ₹510.0m in cash offsetting this, leading to net cash of ₹410.0m.
How Healthy Is Kennametal India's Balance Sheet?
The latest balance sheet data shows that Kennametal India had liabilities of ₹1.73b due within a year, and liabilities of ₹161.0m falling due after that. On the other hand, it had cash of ₹510.0m and ₹1.55b worth of receivables due within a year. So it actually has ₹169.0m more liquid assets than total liabilities.
This state of affairs indicates that Kennametal India's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹20.8b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Kennametal India has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Kennametal India has boosted its EBIT by 82%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kennametal India'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 company can only pay off debt with cold hard cash, not accounting profits. While Kennametal India has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Kennametal India reported free cash flow worth 13% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While we empathize with investors who find debt concerning, you should keep in mind that Kennametal India has net cash of ₹410m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 82% over the last year. So we don't have any problem with Kennametal India's use of debt. 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 Kennametal India's earnings per share history for free.
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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