Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” 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. Above all, Pennar Industries Limited (NSE:PENIND) is in debt. But the real question is whether this debt makes the business risky.
What risk does debt carry?
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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Check out our latest analysis for Pennar Industries
How much debt does Pennar Industries have?
The graph below, which you can click on for more details, shows that Pennar Industries had ₹5.88 billion in debt as of March 2022; about the same as the previous year. However, he also had ₹1.32 billion in cash, and hence his net debt is ₹4.56 billion.
How healthy is Pennar Industries’ balance sheet?
The latest balance sheet data shows that Pennar Industries had liabilities of ₹12.3 billion due within a year, and liabilities of ₹1.78 billion falling due thereafter. As compensation for these obligations, he had cash of ₹1.32 billion as well as receivables valued at ₹4.25 billion due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by ₹8.48 billion.
This deficit casts a shadow over the ₹4.68 billion society like a colossus towering above mere mortals. So we definitely think shareholders need to watch this one closely. Ultimately, Pennar Industries would likely need a major recapitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
While Pennar Industries’ debt to EBITDA ratio (2.7) suggests it is using some debt, its interest coverage is very low at 1.5, suggesting high leverage. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. However, shareholders should be reassured to remember that Pennar Industries has actually increased its EBIT by 138% over the past 12 months. If this earnings trend continues, it will make its leverage much more manageable in the future. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in total isolation; since Pennar Industries will need revenue 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, Pennar Industries’ free cash flow has been 48% of EBIT, less than expected. It’s not great when it comes to paying off debt.
Our point of view
At first glance, Pennar Industries’ interest coverage left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign and makes us more optimistic. Looking at the balance sheet and taking all of these factors into account, we think the debt makes Pennar Industries stock a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. Know that Pennar Industries shows 4 warning signs in our investment analysis and 2 of them make us uncomfortable…
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.