Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We can see that Shemaroo Entertainment Limited (NSE:SHEMAROO) does use debt in its business. But should shareholders be worried about its use of debt?
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. 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.
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How Much Debt Does Shemaroo Entertainment Carry?
As you can see below, at the end of September 2022, Shemaroo Entertainment had ₹2.97b of debt, up from ₹2.50b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn’t have much cash.
A Look At Shemaroo Entertainment’s Liabilities
According to the last reported balance sheet, Shemaroo Entertainment had liabilities of ₹3.55b due within 12 months, and liabilities of ₹181.1m due beyond 12 months. Offsetting these obligations, it had cash of ₹27.0m as well as receivables valued at ₹1.44b due within 12 months. So its liabilities total ₹2.26b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of ₹3.70b, so it does suggest shareholders should keep an eye on Shemaroo Entertainment’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Shemaroo Entertainment shareholders face the double whammy of a high net debt to EBITDA ratio (7.3), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. This means we’d consider it to have a heavy debt load. The good news is that Shemaroo Entertainment improved its EBIT by 8.2% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shemaroo Entertainment’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent two years, Shemaroo Entertainment recorded free cash flow of 35% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
On the face of it, Shemaroo Entertainment’s interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Shemaroo Entertainment stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Shemaroo Entertainment has 3 warning signs (and 2 which are potentially serious) we think you should know about.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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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.