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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Prism Johnson Limited (NSE:PRSMJOHNSN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Prism Johnson
How Much Debt Does Prism Johnson Carry?
The image below, which you can click on for greater detail, shows that Prism Johnson had debt of ₹18.9b at the end of March 2019, a reduction from ₹20.2b over a year. However, it does have ₹1.81b in cash offsetting this, leading to net debt of about ₹17.1b.
How Healthy Is Prism Johnson's Balance Sheet?
The latest balance sheet data shows that Prism Johnson had liabilities of ₹23.7b due within a year, and liabilities of ₹17.2b falling due after that. Offsetting these obligations, it had cash of ₹1.81b as well as receivables valued at ₹8.95b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹30.1b.
This is a mountain of leverage relative to its market capitalization of ₹41.1b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).