Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that The Western India Plywoods Limited (NSE: WIPL) uses debt in its operations. But the more important question is: what risk does this debt create?
Why is debt risky?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for West India Plywoods
How much debt does Western India Plywoods have?
The graph below, which you can click on for more details, shows that Western India Plywoods had a debt of ₹180.3 million as of September 2021; about the same as the previous year. However, he has ₹24.3 million of cash to offset this, resulting in a net debt of around ₹156.0 million.
How healthy is Western India Plywoods’ balance sheet?
Zooming in on the latest balance sheet data, we can see that Western India Plywoods had liabilities of ₹149.9 million due within 12 months and liabilities of ₹146.5 million due beyond. As compensation for these obligations, it had cash of ₹24.3 million as well as receivables valued at ₹193.4 million due within 12 months. Thus, its liabilities total £78.7 million more than the combination of its cash and short-term receivables.
Considering that Western India Plywoods has a market capitalization of ₹500.3 million, it is hard to believe that these liabilities pose a big threat. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
While Western India Plywoods’ debt to EBITDA ratio (4.2) suggests it uses some debt, its interest coverage is very low at 0.65, suggesting high leverage. This is largely due to the company’s large amortization charges, which no doubt means that its EBITDA is a very generous measure of earnings, and that its debt may be heavier than it first appears. on board. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Worse still, Western India Plywoods has seen its EBIT drop by 30% in the past 12 months. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is the profits of Western India Plywoods that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Western India Plywoods has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
Neither Western India Plywoods’ ability to increase its EBIT nor its interest coverage gave us confidence in its ability to take on more debt. But the good news is that it seems to be able to easily convert EBIT to free cash flow. We think Western India Plywoods’ debt makes it a bit risky, after looking at the aforementioned data points together. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. Be aware that Western India Plywoods shows 4 warning signs in our investment analysis and 3 of them make us uncomfortable…
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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