Here's Why Tata Power (NSE:TATAPOWER) Has A Meaningful Debt Burden
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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that The Tata Power Company Limited (NSE:TATAPOWER) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
View our latest analysis for Tata Power
What Is Tata Power's Net Debt?
As you can see below, at the end of March 2019, Tata Power had ₹485.0b of debt, up from ₹411.8b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
A Look At Tata Power's Liabilities
Zooming in on the latest balance sheet data, we can see that Tata Power had liabilities of ₹286.6b due within 12 months and liabilities of ₹351.2b due beyond that. On the other hand, it had cash of ₹8.95b and ₹68.7b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹560.1b.
This deficit casts a shadow over the ₹161.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Tata Power would likely require a major re-capitalisation if it had to pay its creditors today.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Tata Power like a one-two punch to the gut. The debt burden here is substantial. On the other hand, Tata Power grew its EBIT by 24% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tata Power 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Tata Power recorded free cash flow worth 55% 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.
Our View
On the face of it, Tata Power's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like Tata Power commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Tata Power's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if Tata Power insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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