Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Pricol Limited (NSE:PRICOLLTD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Pricol's Net Debt?
The image below, which you can click on for greater detail, shows that Pricol had debt of ₹2.79b at the end of March 2019, a reduction from ₹4.49b over a year. However, it does have ₹589.5m in cash offsetting this, leading to net debt of about ₹2.20b.
How Strong Is Pricol's Balance Sheet?
According to the last reported balance sheet, Pricol had liabilities of ₹9.33b due within 12 months, and liabilities of ₹1.65b due beyond 12 months. Offsetting these obligations, it had cash of ₹589.5m as well as receivables valued at ₹2.04b due within 12 months. So it has liabilities totalling ₹8.36b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the ₹3.32b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt At the end of the day, Pricol would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
While Pricol has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 1.5. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Pricol's EBIT was down 72% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Pricol 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Pricol saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Pricol's EBIT growth rate 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. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Considering all the factors previously mentioned, we think that Pricol really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. While Pricol didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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