Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. 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. We can see that Gujarat Industries Power Company Limited (NSE: GIPCL) uses debt in its business. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Gujarat Industries Power
What is Gujarat Industries Power’s net debt?
The image below, which you can click on for more details, shows that as of September 2021, Gujarat Industries Power had a debt of ₹4.86 billion, up from ₹3.89 billion in a year . However, he also had ₹1.52 billion in cash, and hence his net debt is ₹3.34 billion.
A look at the responsibilities of Gujarat Industries Power
The latest balance sheet data shows that Gujarat Industries Power had liabilities of ₹5.58 billion due within one year, and liabilities of ₹6.68 billion falling due thereafter. On the other hand, it had cash of ₹1.52 billion and ₹2.89 billion of receivables due within one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by ₹7.85 billion.
This deficit is sizable compared to its market capitalization of ₹11.6 billion, so it suggests shareholders to watch Gujarat Industries Power’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (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 ).
Gujarat Power Industries has a low net debt to EBITDA ratio of just 0.85. And its EBIT covers its interest charges 54.4 times. So we’re pretty relaxed about his super-conservative use of debt. But the bad news is that Gujarat Industries Power has seen its EBIT fall by 11% over the last twelve months. We believe that this type of performance, if repeated frequently, could well spell trouble for the stock. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in total isolation; since Gujarat Industries Power will need revenue to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Gujarat Industries Power has recorded free cash flow of 28% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.
Our point of view
Gujarat Industries Power’s EBIT growth rate and the level of its total liabilities are certainly weighing on it, in our view. But his coverage of interest tells a very different story and suggests a certain resilience. When we consider all the factors mentioned, it seems to us that Gujarat Industries Power is taking risks with its use of debt. While this debt may increase returns, we believe the company now has sufficient leverage. 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. We have identified 1 warning sign with Gujarat Industries Power, and understanding them should be part of your investment process.
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.
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