We think Birla (NSE:BIRLACORPN) is taking risks with its debt
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Like many other companies Birla Company Limited (NSE:BIRLACORPN) uses 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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest review for Birla
What is Birla’s net debt?
The image below, which you can click on for more details, shows that as of September 2021, Birla had a debt of ₹40.8 billion, up from ₹34.7 billion in a year. On the other hand, he has ₹5.24 billion in cash, resulting in a net debt of around ₹35.6 billion.
How healthy is Birla’s balance sheet?
We can see from the most recent balance sheet that Birla had liabilities of ₹20.3 billion due within a year, and liabilities of ₹54.2 billion due beyond. In return, he had ₹5.24 billion in cash and ₹3.22 billion in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by ₹66.0 billion.
This deficit is sizable compared to its market capitalization of ₹80.2 billion, so it suggests shareholders to monitor Birla’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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). 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 ).
Birla’s debt is 2.9 times its EBITDA and its EBIT covers its interest expense 3.8 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. Another concern for investors could be that Birla’s EBIT fell 10% last year. If things continue like this, dealing with debt will be about as easy as putting an angry house cat in its travel box. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Birla’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay off its debts with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Birla has recorded a free cash flow of 46% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
At first glance, Birla’s level of total liabilities left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But at least its EBIT to free cash flow conversion isn’t that bad. Looking at the bigger picture, it seems clear to us that Birla’s use of debt creates risks for the business. If all goes well, this should boost returns, but on the other hand, the risk of permanent capital loss is increased by debt. 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. For example, we have identified 2 warning signs for Birla which you should be aware of.
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.