David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Hind Rectifiers Limited (NSE:HIRECT) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Hind Rectifiers's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Hind Rectifiers had ₹636.4m of debt, an increase on ₹509.3m, over one year. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Hind Rectifiers's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hind Rectifiers had liabilities of ₹874.1m due within 12 months and liabilities of ₹189.8m due beyond that. Offsetting this, it had ₹2.52m in cash and ₹665.4m in receivables that were due within 12 months. So its liabilities total ₹396.0m more than the combination of its cash and short-term receivables.
Of course, Hind Rectifiers has a market capitalization of ₹2.05b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Hind Rectifiers's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 4.3 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Hind Rectifiers's EBIT launched higher than Elon Musk, gaining a whopping 134% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hind Rectifiers will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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, Hind Rectifiers burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Hind Rectifiers's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to grow its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Hind Rectifiers's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that Hind Rectifiers insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.