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.' 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. We can see that E.I.D.- Parry (India) Limited (NSE:EIDPARRY) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is E.I.D.- Parry (India)'s Debt?
The image below, which you can click on for greater detail, shows that at March 2019 E.I.D.- Parry (India) had debt of ₹59.2b, up from ₹51.5b in one year. However, because it has a cash reserve of ₹2.57b, its net debt is less, at about ₹56.6b.
How Healthy Is E.I.D.- Parry (India)'s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that E.I.D.- Parry (India) had liabilities of ₹109.1b due within 12 months and liabilities of ₹6.25b due beyond that. Offsetting these obligations, it had cash of ₹2.57b as well as receivables valued at ₹49.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹63.0b.
This deficit casts a shadow over the ₹27.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, E.I.D.- Parry (India) would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
E.I.D.- Parry (India) has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that E.I.D.- Parry (India) grew its EBIT a smooth 39% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is E.I.D.- Parry (India)'s earnings that will influence how the balance sheet holds up in the future. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, E.I.D.- Parry (India)'s free cash flow amounted to 25% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over E.I.D.- Parry (India)'s attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it's fair to say that E.I.D.- Parry (India) has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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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