Is Fairchem Speciality (NSE:FAIRCHEM) A Risky Investment?
Simply Wall St
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Fairchem Speciality Limited (NSE:FAIRCHEM) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
The image below, which you can click on for greater detail, shows that at March 2019 Fairchem Speciality had debt of ₹4.91b, up from ₹3.30b in one year. However, because it has a cash reserve of ₹162.6m, its net debt is less, at about ₹4.75b.
NSEI:FAIRCHEM Historical Debt, August 29th 2019
How Strong Is Fairchem Speciality's Balance Sheet?
The latest balance sheet data shows that Fairchem Speciality had liabilities of ₹6.30b due within a year, and liabilities of ₹2.20b falling due after that. Offsetting these obligations, it had cash of ₹162.6m as well as receivables valued at ₹3.41b due within 12 months. So its liabilities total ₹4.93b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Fairchem Speciality is worth ₹19.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Fairchem Speciality's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 6.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Fairchem Speciality's EBIT launched higher than Elon Musk, gaining a whopping 130% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Fairchem Speciality can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Fairchem Speciality burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Fairchem Speciality's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Fairchem Speciality's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We'd be motivated to research the stock further if we found out that Fairchem Speciality insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
