Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Above all, NHPC Limited (NSE:NHPC) is in debt. But does this debt worry shareholders?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
See our latest analysis for NHPC
What is NHPC’s debt?
As you can see below, at the end of March 2022, NHPC had a debt of ₹281.1 billion, up from ₹240.2 billion a year ago. Click on the image for more details. However, he has ₹17.3 billion in cash to offset this, resulting in a net debt of around ₹263.8 billion.
A Look at NHPC’s Responsibilities
According to the latest published balance sheet, NHPC had liabilities of ₹86.2 billion due within 12 months and liabilities of ₹308.8 billion due beyond 12 months. As compensation for these obligations, it had cash of ₹17.3 billion as well as receivables valued at ₹62.0 billion due within 12 months. Thus, its liabilities total ₹315.7 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable compared to its market capitalization of ₹350.6 billion, so it suggests shareholders to monitor NHPC’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Strangely, NHPC has a sky-high EBITDA ratio of 5.1, implying high debt, but high interest coverage of 17.7. This means that unless the company has access to very cheap debt, these interest charges will likely increase in the future. We have seen NHPC increase its EBIT by 3.1% over the last twelve months. It’s far from amazing, but it’s a good thing when it comes to paying down debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether NHPC can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, NHPC’s free cash flow has been 39% of its EBIT, less than we expected. That’s not great when it comes to paying off debt.
Our point of view
Neither NHPC’s ability to manage its debt, on an EBITDA basis, nor its level of total liabilities gave us confidence in its ability to take on more debt. But his coverage of interest tells a very different story and suggests a certain resilience. Considering the above factors, we believe that NHPC’s debt poses certain risks to the business. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example, we found 3 warning signs for NHPC which you should be aware of before investing here.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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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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