Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, The Indian Hume Pipe Company Limited (NSE:INDIANHUME) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Indian Hume Pipe's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Indian Hume Pipe had debt of ₹4.74b, up from ₹4.51b in one year. However, because it has a cash reserve of ₹186.5m, its net debt is less, at about ₹4.56b.
How Healthy Is Indian Hume Pipe's Balance Sheet?
We can see from the most recent balance sheet that Indian Hume Pipe had liabilities of ₹12.1b falling due within a year, and liabilities of ₹573.9m due beyond that. On the other hand, it had cash of ₹186.5m and ₹13.8b worth of receivables due within a year. So it actually has ₹1.32b more liquid assets than total liabilities.
This short term liquidity is a sign that Indian Hume Pipe could probably pay off its debt with ease, as its balance sheet is far from stretched.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Indian Hume Pipe's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 3.2 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Indian Hume Pipe grow its EBIT by 5.5% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Indian Hume Pipe's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Indian Hume Pipe recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Indian Hume Pipe's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to handle its total liabilities isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Indian Hume Pipe is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Indian Hume Pipe's earnings per share history for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.