Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Like many other companies Nahar Spinning Mills Ltd (NSE: NAHARSPING) uses debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest review for Nahar Spinning Mills
What is the net debt of Nahar Spinning Mills?
As you can see below, at the end of March 2021, Nahar Spinning Mills had 10.7 billion yen in debt, up from 9.24 billion yen a year ago. Click on the image for more details. Net debt is about the same because it doesn’t have a lot of cash.
How healthy is Nahar Spinning Mills’ track record?
We can see from the most recent balance sheet that Nahar Spinning Mills had liabilities of 10.9 billion yen maturing within one year and liabilities of 2.14 billion yen beyond. In return, he had 17.6 million in cash and 3.33 million in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and its (short-term) receivables by 9.69.
When you consider that this shortfall exceeds the company’s ₹ 7.12b market cap, you might well be inclined to take a close look at the balance sheet. Hypothetically, an extremely high dilution would be necessary if the company were forced to repay its debts by raising capital at the current share price.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
The low interest coverage of 1.7 times and an extremely high net debt to EBITDA ratio of 5.5 affected our confidence in Nahar Spinning Mills like a punch in the gut. This means that we would consider him to be in heavy debt. However, the bright side is that Nahar Spinning Mills achieved a positive EBIT of 1.1 billion yen in the past twelve months, an improvement over the loss of the previous year. The balance sheet is clearly the area you need to focus on when analyzing debt. But you can’t look at debt in isolation; since Nahar Spinning Mills will need income to pay off this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore important to check how much of its earnings before interest and taxes (EBIT) converts into actual free cash flow. Over the past year, Nahar Spinning Mills has experienced substantial total negative free cash flow. While investors no doubt expect this situation to reverse in due course, this clearly means its use of debt is riskier.
Our point of view
To be frank, Nahar Spinning Mills’ interest coverage and track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. That said, his ability to increase his EBIT is not that much of a concern. After looking at the data points discussed, we believe Nahar Spinning Mills has too much debt. This kind of risk is acceptable to some, but it certainly does not float our boat. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Nahar Spinning Mills has 5 warning signs (and 2 which don’t suit us very well) we think you should be aware of.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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