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. As with many other companies Polycab India Limited (NSE:POLYCAB) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Polycab India's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Polycab India had ₹2.72b of debt in March 2019, down from ₹8.00b, one year before. However, its balance sheet shows it holds ₹3.18b in cash, so it actually has ₹458.2m net cash.
A Look At Polycab India's Liabilities
Zooming in on the latest balance sheet data, we can see that Polycab India had liabilities of ₹26.2b due within 12 months and liabilities of ₹1.54b due beyond that. Offsetting these obligations, it had cash of ₹3.18b as well as receivables valued at ₹14.2b due within 12 months. So its liabilities total ₹10.3b more than the combination of its cash and short-term receivables.
Since publicly traded Polycab India shares are worth a total of ₹82.8b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Polycab India boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that Polycab India grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Polycab 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 Polycab 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. During the last three years, Polycab India produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Polycab India's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of ₹458m. And it impressed us with free cash flow of ₹9.4b, being 68% of its EBIT. So is Polycab India's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Polycab India, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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