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. “. It is natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that Sutlej Textiles and Industries Limited (NSE: SUTLEJTEX) uses debt in his business. But should shareholders be worried about its use of debt?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is the debt of Sutlej Textiles and Industries?
You can click on the graph below for historical figures, but it shows Sutlej Textiles and Industries had 7.80 billion yen in debt in March 2021, up from 8.73 billion yen a year earlier. However, he also had 823.6 million yen in cash, so his net debt is 6.97 billion yen.
How strong is Sutlej Textiles and Industries’ balance sheet?
Zooming in on the latest balance sheet data, we can see that Sutlej Textiles and Industries had a liability of 6.73b due within 12 months and a liability of and5.11b due beyond. In return, he had 823.6 million yen in cash and 2.76 billion yen in receivables due within 12 months. Its liabilities are therefore 8.26 billion euros more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market capitalization of 10.3 billion euros. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
The low 0.23 times interest coverage and an extremely high net debt to EBITDA ratio of 6.7 hit our confidence in Sutlej Textiles and Industries like a punch in the gut. The debt burden here is considerable. Worse yet, Sutlej Textiles and Industries’ EBIT fell 89% from last year. If the income continues like this for the long term, there is an incredible chance to pay off that debt. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since Sutlej Textiles and Industries will need revenue to pay off this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Sutlej Textiles and Industries has generated more free cash flow than EBIT. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
At first glance, Sutlej Textiles and Industries’ interest hedging left us hesitant about the stock, and its EBIT growth rate was no more attractive than the lone empty restaurant on the busiest night of the week. ‘year. But at least it’s pretty decent to convert EBIT into free cash flow; it’s encouraging. Overall, it seems clear to us that the reliance on debt by Sutlej Textiles and Industries creates risks for the business. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. Know that Sutlej Textiles and Industries displays 4 warning signs in our investment analysis , and 2 of them are a bit disturbing …
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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