Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Mold-Tek Packaging Limited (NSE:MOLDTKPAC) does carry debt. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Mold-Tek Packaging's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Mold-Tek Packaging had ₹1.03b of debt, an increase on ₹951.7m, over one year. However, because it has a cash reserve of ₹36.2m, its net debt is less, at about ₹992.8m.
How Strong Is Mold-Tek Packaging's Balance Sheet?
According to the last reported balance sheet, Mold-Tek Packaging had liabilities of ₹1.29b due within 12 months, and liabilities of ₹342.1m due beyond 12 months. On the other hand, it had cash of ₹36.2m and ₹720.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹879.4m.
Of course, Mold-Tek Packaging has a market capitalization of ₹7.52b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Looking at its net debt to EBITDA of 1.4 and interest cover of 6.6 times, it seems to us that Mold-Tek Packaging is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If Mold-Tek Packaging can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Mold-Tek Packaging can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, Mold-Tek Packaging burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mold-Tek Packaging's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to grow its EBIT isn't too shabby at all. We think that Mold-Tek Packaging's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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