Is Transformers & Rectifiers (India) (NSE:TRIL) A Risky Investment?
Simply Wall St
Warren Buffett famously said, '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. Importantly, Transformers & Rectifiers (India) Limited (NSE:TRIL) does carry debt. But the real question is whether this debt is making the company risky.
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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Transformers & Rectifiers (India)'s Net Debt?
The image below, which you can click on for greater detail, shows that Transformers & Rectifiers (India) had debt of ₹2.41b at the end of March 2019, a reduction from ₹3.99b over a year. However, it also had ₹297.2m in cash, and so its net debt is ₹2.11b.
NSEI:TRIL Historical Debt, September 10th 2019
How Strong Is Transformers & Rectifiers (India)'s Balance Sheet?
We can see from the most recent balance sheet that Transformers & Rectifiers (India) had liabilities of ₹5.00b falling due within a year, and liabilities of ₹362.8m due beyond that. Offsetting this, it had ₹297.2m in cash and ₹3.80b in receivables that were due within 12 months. So it has liabilities totalling ₹1.27b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of ₹1.11b, we think shareholders really should watch Transformers & Rectifiers (India)'s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Transformers & Rectifiers (India)'s net debt to EBITDA ratio of 3.7, we think its super-low interest cover of 0.91 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Transformers & Rectifiers (India)'s EBIT fell 14% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Transformers & Rectifiers (India) 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.
Finally, while the tax-man may adore accounting profits, lenders only accept 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 most recent three years, Transformers & Rectifiers (India) 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.
Our View
Mulling over Transformers & Rectifiers (India)'s attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Transformers & Rectifiers (India)'s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you're interested in Transformers & Rectifiers (India), you may well want to click here to check an interactive graph of its earnings per share history.
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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.
