Backed by Berkshire Hathaway’s Charlie Munger, outside fund manager Li Lu makes no bones about it when he says, “The biggest investment risk isn’t price volatility, it’s whether you will suffer a permanent loss of capital.” It’s only natural to consider a company’s balance sheet when examining how risky it is, since debt is often at play when a company fails. We note that Indian Oil Corporation Limited (NSE:IOC) has debt on its balance sheet. But the real question is whether that debt makes the company risky.
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it’s at their mercy. Ultimately, if the company fails to meet its legal obligations to pay down debt, shareholders could get away with nothing. While not all that common, we often see leveraged companies permanently diluting shareholders as lenders force them to raise capital at a distressed price. Of course, many companies use debt to fund growth, with no ill effects. When thinking about a company’s use of debt, let’s first consider cash and debt together.
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How Much Debt Does Indian Oil Have?
As you can see below, Indian Oil had debts of ₹1.32t at the end of March 2022, up from ₹1.09t a year ago. Click on the picture for more details. However, it also had £98.3bn in cash, leaving its net debt at £1.22t.
How healthy is Indian Oil’s balance sheet?
We can see from the most recent balance sheet that Indian Oil had £1.92 trillion in debt maturing within a year and £833.4 billion in debt maturing beyond that. To offset this, it had £98.3bn in cash and £205.2bn in receivables due within 12 months. Therefore, his liabilities outweigh the sum of his cash and (short-term) receivables by 2.45t.
The shortage here weighs heavily on the £942.7bn company itself, like a child struggling under the weight of a huge backpack full of books, its sports gear and a trumpet. So we definitely think shareholders should watch this closely. After all, Indian Oil would likely need a major recapitalization if it had to pay its creditors today.
We use two main metrics to tell us about debt versus earnings. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), the second is how often earnings before interest and taxes (EBIT) cover its interest expense (or interest coverage for short). . 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).
Indian Oil’s debt is 2.9 times its EBITDA, and its EBIT covers its interest expense 5.0 times more. This suggests that while the leverage is significant, we wouldn’t call it problematic. Unfortunately, Indian Oil’s EBIT has plummeted 17% over the past four quarters. If earnings continue to fall at this rate, managing the debt will be harder than taking three kids under five to a fancy trouser restaurant. Undoubtedly, we learn most about debt from the balance sheet. But it’s future earnings above all else that will determine Indian Oil’s ability to maintain a healthy balance sheet going forward. So if you focus on the future, you can check this free Analyst earnings forecast report.
After all, a company can only pay off debts with hard cash, not with accounting profits. So the logical step is to look at the proportion of that EBIT that corresponds to actual free cash flow. Over the past three years, Indian Oil has generated free cash flow equivalent to 7.6% of its EBIT, an uninspiring performance. For us, a cash conversion so low that inspires a little paranoia is the ability to pay down debt.
Our view
At first glance, Indian Oil’s EBIT growth rate left us hesitant about the stock, and the level of total debt was no more enticing than that one empty restaurant on the busiest night of the year. But at least its interest coverage isn’t that bad. After considering the data points discussed, we believe Indian Oil is over-leveraged. That kind of risk is okay for some, but it certainly doesn’t make us swim. Undoubtedly, we learn most about debt from the balance sheet. But ultimately, any business can have off-balance-sheet risks. We have identified 3 warning signs with Indian Oil (at least 1, which is a little awkward), and understanding these factors should be part of your investment process.
If, after all that, you’re more interested in a fast-growing company with a rock-solid balance sheet, check out our list of net cash growth stocks right away.
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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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