Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Chambal Fertilisers and Chemicals Limited (NSE:CHAMBLFERT) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Chambal Fertilisers and Chemicals Carry?
As you can see below, at the end of March 2019, Chambal Fertilisers and Chemicals had ₹86.9b of debt, up from ₹60.8b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹2.49b, its net debt is less, at about ₹84.4b.
NSEI:CHAMBLFERT Historical Debt, August 30th 2019
How Healthy Is Chambal Fertilisers and Chemicals's Balance Sheet?
The latest balance sheet data shows that Chambal Fertilisers and Chemicals had liabilities of ₹65.3b due within a year, and liabilities of ₹46.2b falling due after that. On the other hand, it had cash of ₹2.49b and ₹48.3b worth of receivables due within a year. So its liabilities total ₹60.6b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₹63.7b, so it does suggest shareholders should keep an eye on Chambal Fertilisers and Chemicals's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Chambal Fertilisers and Chemicals has a rather high debt to EBITDA ratio of 6.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.6 times, suggesting it can responsibly service its obligations. Looking on the bright side, Chambal Fertilisers and Chemicals boosted its EBIT by a silky 45% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chambal Fertilisers and Chemicals'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 report on analyst profit forecasts to be interesting.
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. Over the last three years, Chambal Fertilisers and Chemicals saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, Chambal Fertilisers and Chemicals's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Chambal Fertilisers and Chemicals's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
