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.' 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. Importantly, SRF Limited (NSE:SRF) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for SRF

What Is SRF's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 SRF had ₹37.3b of debt, an increase on ₹31.4b, over one year. However, it also had ₹2.92b in cash, and so its net debt is ₹34.4b.

How Strong Is SRF's Balance Sheet?

We can see from the most recent balance sheet that SRF had liabilities of ₹32.0b falling due within a year, and liabilities of ₹25.6b due beyond that. Offsetting these obligations, it had cash of ₹2.92b as well as receivables valued at ₹15.4b due within 12 months. So it has liabilities totalling ₹39.2b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since SRF has a market capitalization of ₹154.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).