Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried “. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Emami Paper Mills Limited (NSE: EMAMIPAP) has debt on its balance sheet. But the most important question is: what risk does this debt create?
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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. 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. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest review for Emami Paper Mills
What is the net debt of Emami Paper Mills?
The image below, which you can click for more details, shows that Emami Paper Mills had a debt of 9.13 billion yen at the end of March 2021, a reduction from the 14.1 billion yen over one year. However, he also had 275.4 million yen in cash, so his net debt is 8.85 billion yen.
A look at the responsibilities of Emami Paper Mills
Zooming in on the latest balance sheet data, we can see that Emami Paper Mills had a liability of 7.38 billion yen owed within 12 months and liabilities of 5.11 billion yen beyond. On the other hand, he had 275.4 million yen in cash and 2.01 billion yen in receivables due within one year. Its liabilities therefore total 10.2 billion euros more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market cap of 11.5 billion yen. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While we’re not worried about Emami Paper Mills’ net debt to EBITDA ratio of 4.9, we do think its ultra-low 1.1 times interest coverage is a sign of high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Worse yet, Emami Paper Mills’ EBIT was down 37% from last year. If the income continues like this for the long haul, there is an incredible chance to pay off that debt. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in isolation; since Emami Paper Mills will need income to repay this debt. So, if you want to know more about its profits, it may be worth checking out this chart of its long term profit trend.
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. Fortunately for all shareholders, Emami Paper Mills has actually generated more free cash flow than EBIT over the past three years. There is nothing better than cash flow to stay in the good graces of your lenders.
Our point of view
To be frank, Emami Paper Mills’ interest coverage and track record of (not) growing its EBIT makes us rather uncomfortable with its debt levels. But on the positive side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. Overall, we think it’s fair to say that Emami Paper Mills has enough debt that there is real risk around the balance sheet. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. To this end, you should inquire about the 4 warning signs we spotted with Emami Paper Mills (2 of which are a bit nasty).
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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