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.' 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 Shakti Pumps (India) Limited (NSE:SHAKTIPUMP) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shakti Pumps (India)

How Much Debt Does Shakti Pumps (India) Carry?

As you can see below, at the end of March 2019, Shakti Pumps (India) had ₹1.70b of debt, up from ₹1.06b a year ago. Click the image for more detail. On the flip side, it has ₹256.0m in cash leading to net debt of about ₹1.44b.

A Look At Shakti Pumps (India)'s Liabilities

We can see from the most recent balance sheet that Shakti Pumps (India) had liabilities of ₹2.55b falling due within a year, and liabilities of ₹376.8m due beyond that. Offsetting these obligations, it had cash of ₹256.0m as well as receivables valued at ₹1.81b due within 12 months. So its liabilities total ₹863.0m more than the combination of its cash and short-term receivables.

Since publicly traded Shakti Pumps (India) shares are worth a total of ₹5.17b, it seems unlikely that this level of liabilities would be a major threat. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shakti Pumps (India) has net debt worth 1.7 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Shakti Pumps (India) could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 11%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shakti Pumps (India) can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Shakti Pumps (India) recorded free cash flow of 20% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shakti Pumps (India)'s conversion of EBIT to free cash flow was a real negative on this analysis, as was its interest cover. On the other hand, we found comfort in its relatively strong EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about Shakti Pumps (India)'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 Shakti Pumps (India) 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.

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 editorial-team@simplywallst.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.