The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Suprajit Engineering Limited (NSE:SUPRAJIT) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Suprajit Engineering Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Suprajit Engineering had ₹3.44b of debt, an increase on ₹3.26b, over one year. However, it does have ₹2.77b in cash offsetting this, leading to net debt of about ₹669.6m.
How Strong Is Suprajit Engineering’s Balance Sheet?
We can see from the most recent balance sheet that Suprajit Engineering had liabilities of ₹5.78b falling due within a year, and liabilities of ₹1.17b due beyond that. Offsetting this, it had ₹2.77b in cash and ₹3.03b in receivables that were due within 12 months. So its liabilities total ₹1.15b more than the combination of its cash and short-term receivables.
Given Suprajit Engineering has a market capitalization of ₹40.4b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Suprajit Engineering has net debt of just 0.31 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.8 times, which is more than adequate. But the bad news is that Suprajit Engineering has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Suprajit Engineering 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Suprajit Engineering recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Suprajit Engineering’s net debt to EBITDA suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But the stark truth is that we are concerned by its EBIT growth rate. When we consider the range of factors above, it looks like Suprajit Engineering is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance…