Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that Kanani Industries Limited (NSE:KANANIIND) has debt on its balance sheet. But does this debt worry shareholders?
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. 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. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for Kanani Industries
How much debt does Kanani Industries have?
As you can see below, at the end of March 2022, Kanani Industries had a debt of ₹244.8 million, up from ₹221.8 million a year ago. Click on the image for more details. However, since he has a cash reserve of ₹45.8 million, his net debt is lower at around ₹199.0 million.
How strong is Kanani Industries’ balance sheet?
We can see from the most recent balance sheet that Kanani Industries had liabilities of ₹816.1 million due within a year, and liabilities of ₹5.90 million due beyond. In return, he had ₹45.8 million in cash and ₹1.02 billion in receivables due within 12 months. He can therefore boast of having ₹247.7 million more liquid assets than total Passives.
It’s good to see that Kanani Industries has plenty of cash on its balance sheet, suggesting conservative liability management. Given that he has easily sufficient short-term cash, we don’t think he will have any problems with his lenders.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Kanani Industries shareholders face the double whammy of a high net debt to EBITDA ratio (11.6) and quite low interest coverage, as EBIT is only 2.1 times expenses of interests. This means that we would consider him to be heavily indebted. The silver lining is that Kanani Industries grew its EBIT by 111% last year, which feeds like youthful idealism. If this earnings trend continues, it will make its leverage much more manageable in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in total isolation; since Kanani Industries will need revenue to repay this debt. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Kanani Industries has actually produced more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our point of view
The good news is that Kanani Industries’ demonstrated ability to convert EBIT into free cash flow delights us like a fluffy puppy does a toddler. But we have to admit that we see that its net debt to EBITDA has the opposite effect. Zooming out, Kanani Industries seems to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. 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. We have identified 3 warning signs with Kanani Industries, and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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.