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.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that State of Gujarat Petronet Limited (NSE: GSPL) uses debt in its business. But does this debt worry shareholders?
What risk does debt entail?
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. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. 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. The first step in examining a business’s debt levels is to consider its cash flow and debt together.
See our latest review for Gujarat State Petronet
What is the debt of the State of Gujarat Petronet?
You can click on the graph below for historical figures, but it shows that Gujarat State Petronet had 10.0 billion yen in debt in September 2021, up from 20.4 billion yen a year earlier. On the other hand, he has 6.95 billion yen in cash, resulting in net debt of around 3.08 billion yen.
How strong is the state of Gujarat Petronet’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Gujarat State Petronet had liabilities of 31.0 billion yen due within 12 months and liabilities of 20.8 billion yen beyond. In return, he had 6.95 billion yen in cash and 9.47 billion yen in receivables due within 12 months. It therefore has liabilities totaling 35.4 billion yen more than its cash and short-term receivables combined.
Of course, Gujarat State Petronet has a market cap of 177.5 billion yen, so this liability is probably manageable. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.
Gujarat State Petronet has very little debt (net of cash) and has a debt to EBITDA ratio of 0.081 and EBIT of 43.2 times interest expense. Compared to past profits, debt therefore seems insignificant. Also positive, Gujarat State Petronet has increased its EBIT by 21% over the past year, which should make it easier to pay down debt going forward. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine Gujarat State Petronet’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with accounting profits. We therefore always check how much of this EBIT is converted into free cash flow. In the past three years, Gujarat State Petronet has recorded free cash flow of 71% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Gujarat State Petronet’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. And that’s just the start of the good news as its net debt to EBITDA is also very encouraging. It should also be noted that Gujarat State Petronet belongs to the gas utilities sector, which is often considered quite defensive. Overall, we don’t think Gujarat State Petronet is taking bad risks, as its debt load appears modest. The balance sheet therefore seems rather healthy to us. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 1 warning sign for the state of Gujarat Petronet which you should know before investing here.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.