Is CEAT (NSE: CEATLTD) using too much debt?
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest 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. We note that CEAT Limited (NSE: CEATLTD) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies 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.
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How much debt does CEAT bear?
As you can see below, at the end of March 2022, CEAT had ₹22.3 billion in debt, up from ₹15.3 billion a year ago. Click on the image for more details. And he doesn’t have a lot of cash, so his net debt is about the same.
How healthy is CEAT’s balance sheet?
We can see from the most recent balance sheet that CEAT had liabilities of ₹36.6 billion falling due within a year, and liabilities of ₹22.0 billion due beyond. As compensation for these obligations, it had cash of ₹326.4 million as well as receivables valued at ₹12.1 billion due within 12 months. Thus, its liabilities total ₹46.2 billion more than the combination of its cash and short-term receivables.
This deficit is sizable compared to its market capitalization of ₹67.2 billion, so it suggests shareholders should monitor CEAT’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power 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 charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
While CEAT’s debt to EBITDA ratio (3.6) suggests it is using some debt, its interest coverage is very low at 1.4, suggesting high leverage. It looks like the company is incurring significant amortization and amortization costs, so perhaps its leverage is heavier than it first appears, since EBITDA is arguably a generous metric. benefits. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. Worse still, CEAT’s EBIT was down 61% from last year. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether CEAT can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, CEAT has created free cash flow of 8.3% of its EBIT, a performance without interest. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
To be frank, CEAT’s interest coverage and history of (not) growing EBIT makes us rather uncomfortable with its level of leverage. And even its net debt to EBITDA doesn’t inspire much confidence. Overall, it seems to us that CEAT’s balance sheet is really a risk for the company. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. 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 have identified 3 warning signs for CEAT (1 is a bit obnoxious) you should be aware.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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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