David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Lumax Industries Limited (NSE:LUMAXIND) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Lumax Industries

How Much Debt Does Lumax Industries Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 Lumax Industries had ₹1.40b of debt, an increase on ₹1.04b, over one year. On the flip side, it has ₹33.0m in cash leading to net debt of about ₹1.36b.

How Healthy Is Lumax Industries's Balance Sheet?

According to the last reported balance sheet, Lumax Industries had liabilities of ₹7.11b due within 12 months, and liabilities of ₹434.1m due beyond 12 months. Offsetting these obligations, it had cash of ₹33.0m as well as receivables valued at ₹2.32b due within 12 months. So its liabilities total ₹5.20b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Lumax Industries is worth ₹11.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.83 and interest cover of 6.4 times, it seems to us that Lumax Industries is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Fortunately, Lumax Industries grew its EBIT by 2.6% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lumax Industries 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Lumax Industries recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Lumax Industries's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability handle its debt, based on its EBITDA, isn't too shabby at all. When we consider all the factors discussed, it seems to us that Lumax Industries is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Lumax Industries's earnings per share history for free.

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.

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.