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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Rain Industries Limited (NSE:RAIN) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Rain Industries
What Is Rain Industries's Net Debt?
The image below, which you can click on for greater detail, shows that Rain Industries had debt of ₹74.0b at the end of June 2019, a reduction from ₹79.1b over a year. However, it does have ₹9.72b in cash offsetting this, leading to net debt of about ₹64.3b.
A Look At Rain Industries's Liabilities
According to the last reported balance sheet, Rain Industries had liabilities of ₹20.7b due within 12 months, and liabilities of ₹82.9b due beyond 12 months. On the other hand, it had cash of ₹9.72b and ₹14.9b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹79.0b.
This deficit casts a shadow over the ₹34.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Rain Industries would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Rain Industries's debt to EBITDA ratio (4.5) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Rain Industries saw its EBIT tank 60% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Rain Industries's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.