Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that Usha Martin Limited (NSE: USHAMART) uses debt in his business. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Usha Martin’s net debt?
As you can see below, Usha Martin had 4.87 billion yen in debt in March 2021, up from 5.79 billion yen the year before. However, given that it has a cash reserve of 994.6 million yen, its net debt is less, at around 3.87 billion yen.
How strong is Usha Martin’s balance sheet?
According to the latest published balance sheet, Usha Martin had liabilities of 8.11 billion yen due within 12 months and liabilities of 3.88 billion yen due beyond 12 months. In return, he had 994.6 million yen in cash and 5.14 billion yen in receivables due within 12 months. Its liabilities are therefore 5.85 billion euros more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that bad as Usha Martin has a market cap of 19.8 billion yen, and so she could likely strengthen her balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look whether it can manage its debt without dilution.
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). Thus, we consider debt versus earnings with and without amortization charges.
While Usha Martin’s low debt-to-EBITDA ratio of 1.4 suggests only a modest use of debt, the fact that EBIT only covered interest expense 4.6 times over the past year makes think. But the interest payments are certainly enough to make us think about how affordable his debt is. It is also important to note that Usha Martin has increased its EBIT by a very respectable 29% over the past year, improving its ability to repay its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is Usha Martin’s profits that will influence the way the balance sheet looks in the future. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Fortunately for all shareholders, Usha Martin has actually generated more free cash flow than EBIT over the past three years. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
The good news is that Usha Martin’s demonstrated ability to convert EBIT into free cash flow delights us like a fluffy puppy does a toddler. And the good news doesn’t end there, because its EBIT growth rate also supports this impression! Looking at the big picture, we think Usha Martin’s use of debt seems completely reasonable and we don’t care. After all, reasonable leverage can increase returns on equity. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for Usha Martin you should know.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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