Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Vardhman Acrylics Limited (NSE:VARDHACRLC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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 Vardhman Acrylics's Debt?
The image below, which you can click on for greater detail, shows that Vardhman Acrylics had debt of ₹7.50m at the end of March 2019, a reduction from ₹13.3m over a year. However, it does have ₹2.28b in cash offsetting this, leading to net cash of ₹2.28b.
A Look At Vardhman Acrylics's Liabilities
We can see from the most recent balance sheet that Vardhman Acrylics had liabilities of ₹994.8m falling due within a year, and liabilities of ₹201.8m due beyond that. On the other hand, it had cash of ₹2.28b and ₹156.1m worth of receivables due within a year. So it actually has ₹1.24b more liquid assets than total liabilities.
This surplus liquidity suggests that Vardhman Acrylics's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Succinctly put, Vardhman Acrylics boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Vardhman Acrylics has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Vardhman Acrylics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Vardhman Acrylics may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Vardhman Acrylics recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that Vardhman Acrylics has net cash of ₹2.3b, as well as more liquid assets than liabilities. So we don't have any problem with Vardhman Acrylics's use of debt. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Vardhman Acrylics's dividend history, without delay!
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.
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 email@example.com. 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.