Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 Sterling Tools Limited (NSE:STERTOOLS) 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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Sterling Tools’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sterling Tools had ₹980.7m of debt, an increase on ₹872.1m, over one year. However, it also had ₹608.5m in cash, and so its net debt is ₹372.2m.
A Look At Sterling Tools’ Liabilities
The latest balance sheet data shows that Sterling Tools had liabilities of ₹895.2m due within a year, and liabilities of ₹737.8m falling due after that. Offsetting these obligations, it had cash of ₹608.5m as well as receivables valued at ₹410.1m due within 12 months. So its liabilities total ₹614.3m more than the combination of its cash and short-term receivables.
Of course, Sterling Tools has a market capitalization of ₹7.87b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Looking at its net debt to EBITDA of 0.69 and interest cover of 4.8 times, it seems to us that Sterling Tools 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. Importantly, Sterling Tools’s EBIT fell a jaw-dropping 33% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Sterling Tools will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Sterling Tools burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Sterling Tools’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Sterling Tools’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk…