Here’s Why Precot (NSE:PRECOT) Is Weighed Down By Its Debt Load

Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Precot Limited (NSE:PRECOT) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for Precot

How Much Debt Does Precot Carry?

The image below, which you can click on for greater detail, shows that at September 2022 Precot had debt of ₹4.10b, up from ₹2.76b in one year. And it doesn’t have much cash, so its net debt is about the same.

A Look At Precot’s Liabilities

The latest balance sheet data shows that Precot had liabilities of ₹3.46b due within a year, and liabilities of ₹1.86b falling due after that. On the other hand, it had cash of ₹47.8m and ₹1.27b worth of receivables due within a year. So it has liabilities totalling ₹4.00b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₹2.28b 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, Precot would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Precot has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 4.7 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Precot saw its EBIT slide 4.2% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Precot will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Precot recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Precot’s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn’t such a worry. Taking into account all the aforementioned factors, it looks like Precot has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. To that end, you should learn about the 5 warning signs we’ve spotted with Precot (including 2 which are significant) .

If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.