Industry News
Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Menon Bearings Limited(NSE:MENONBE) makes use of debt. But the more important question is: how much risk is that debt creating?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Menon Bearings had ?457.1m of debt, an increase on ?252.7m, over one year. However, it does have ?180.4m in cash offsetting this, leading to net debt of about ?276.7m.
The latest balance sheet data shows that Menon Bearings had liabilities of ?363.5m due within a year, and liabilities of ?310.2m falling due after that. On the other hand, it had cash of ?180.4m and ?400.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ?93.0m.
Since publicly traded Menon Bearings shares are worth a total of ?3.76b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Menon Bearings has a low net debt to EBITDA ratio of only 0.69. And its EBIT easily covers its interest expense, being 17.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Menon Bearings's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of 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 Menon Bearings can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Menon Bearings created free cash flow amounting to 12% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
