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Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that Indian Oil Company Limited (NSE: IOC) uses debt in its business. But the most important question is: what risk does this debt create?
When is debt dangerous?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest review for Indian Oil
What is Indian Oil’s net debt?
You can click on the chart below for historical figures, but it shows Indian Oil had 1.01t of debt in March 2021, up from 1.22t a year earlier. However, he also had 140.1 billion yen in cash, so his net debt is 867.6 billion yen.
A look at the liabilities of Indian Oil
According to the latest published balance sheet, Indian Oil had liabilities of 1.62 t yen due within 12 months and liabilities of 799.3 billion yen due beyond 12 months. In return, he had 140.1 billion yen in cash and 147.9 billion yen in receivables due within 12 months. It therefore has liabilities totaling 2.13 tonnes more than its combined cash and short-term receivables.
This deficit casts a shadow over ₹ 975.9b society, like a towering colossus of mere mortals. So we would be watching its record closely, without a doubt. Ultimately, Indian Oil would likely need a major recapitalization if its creditors demanded repayment.
We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Indian Oil’s net debt of 2.1 times EBITDA suggests a graceful use of debt. And the attractive interest coverage (EBIT of 7.0 times the interest costs) certainly does do not do everything to dispel this impression. Notably, Indian Oil’s EBIT was higher than Elon Musk’s, gaining a whopping 184% from last year. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine Indian Oil’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts‘ earnings forecasts.
Finally, a business can only repay its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Indian Oil has recorded negative free cash flow, in total. Debt is typically more expensive and almost always riskier in the hands of a business with negative free cash flow. Shareholders should hope for improvement.
Our point of view
To be frank, Indian Oil’s conversion of EBIT to free cash flow and its track record of controlling its total liabilities make us rather uncomfortable with its debt levels. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Overall, we think it’s fair to say that Indian Oil has enough debt that there is real risk around the balance sheet. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. To this end, you should inquire about the 3 warning signs we spotted with Indian Oil (including 1 which is potentially serious).
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash net growth stocks.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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