David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the 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. Above all, Oriental Aromatics Limited (NSE:OAL) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, 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 at a low price, thereby permanently diluting shareholders. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for Oriental Aromatics
What is Oriental Aromatics’ debt?
You can click on the graph below for historical figures, but it shows that as of September 2021, Oriental Aromatics had ₹700.4 million in debt, an increase from ₹134.6 million, year on year . However, since he has a cash reserve of ₹108.1 million, his net debt is lower at around ₹592.3 million.
How healthy is Oriental Aromatics’ balance sheet?
According to the latest published balance sheet, Oriental Aromatics had liabilities of ₹1.34 billion due within 12 months and liabilities of ₹592.6 million due beyond 12 months. On the other hand, it had a cash position of ₹108.1 million and ₹1.87 billion in receivables due within a year. Thus, he can boast of ₹42.8 million more liquid assets than total Passives.
This situation indicates that Oriental Aromatics’ balance sheet looks quite strong, as its total liabilities roughly equal its liquid assets. So while it’s hard to imagine the £23.6bn company struggling to find cash, we still think it’s worth keeping an eye on its balance sheet.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Oriental Aromatics has a low net debt to EBITDA ratio of just 0.57. And its EBIT easily covers its interest costs, which is 37.7 times the size. So we’re pretty relaxed about his super conservative use of debt. In fact, Oriental Aromatics’ saving grace is its low level of leverage, as its EBIT has fallen 36% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; because Oriental Aromatics will need income to repay this debt. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
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, Oriental Aromatics has recorded a free cash flow of 38% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.
Our point of view
Oriental Aromatics’ EBIT growth rate was a real negative in this analysis, although the other factors we considered were considerably better. In particular, we are dazzled by its interest coverage. Looking at all this data, we feel a bit cautious about Oriental Aromatics’ debt levels. While we understand that debt can improve returns on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for oriental aromatics you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.