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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that CG Power and Industrial Solutions Limited (NSE:CGPOWER) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does CG Power and Industrial Solutions Carry?
As you can see below, at the end of September 2018, CG Power and Industrial Solutions had ₹19.7b of debt, up from ₹15.1b a year ago. Click the image for more detail. However, it does have ₹4.90b in cash offsetting this, leading to net debt of about ₹14.8b.
A Look At CG Power and Industrial Solutions’s Liabilities
Zooming in on the latest balance sheet data, we can see that CG Power and Industrial Solutions had liabilities of ₹59.2b due within 12 months and liabilities of ₹7.82b due beyond that. Offsetting this, it had ₹4.90b in cash and ₹19.3b in receivables that were due within 12 months. So it has liabilities totalling ₹42.8b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the ₹11.5b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt At the end of the day, CG Power and Industrial Solutions would probably need a major re-capitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While we wouldn’t worry about CG Power and Industrial Solutions’s net debt to EBITDA ratio of 2.7, we think its super-low interest cover of 2.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, CG Power and Industrial Solutions boosted its EBIT by a silky 48% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if CG Power and Industrial Solutions can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, CG Power and Industrial Solutions burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both CG Power and Industrial Solutions’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that CG Power and Industrial Solutions’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While CG Power and Industrial Solutions didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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