David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Above all, Prism Johnson Limited (NSE: PRSMJOHNSN) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Prism Johnson
What is Prism Johnson’s net debt?
You can click on the chart below for historical figures, but it shows Prism Johnson had ₹17.6bn in debt in September 2021, up from ₹20.2bn a year prior. However, he has ₹2.90 billion in cash to offset this, resulting in a net debt of around ₹14.7 billion.
A look at Prism Johnson’s responsibilities
The latest balance sheet data shows that Prism Johnson had liabilities of ₹24.3 billion due within a year, and liabilities of ₹20.7 billion falling due thereafter. In return, he had ₹2.90 billion in cash and ₹6.48 billion in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by ₹35.6 billion.
While that might sound like a lot, it’s not that bad since Prism Johnson has a market capitalization of ₹64.2 billion, and so it could probably bolster its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay debt.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Prism Johnson has a fairly reasonable net debt to EBITDA ratio of 2.4, its interest coverage looks low at 2.0. This suggests that the company is paying quite high interest rates. Regardless, there is no doubt that the stock uses significant leverage. It is also relevant to note that Prism Johnson has increased its EBIT by a very respectable 22% over the past year, improving its ability to repay debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Prism Johnson’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
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, Prism Johnson has actually produced more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our point of view
Based on our analysis, Prism Johnson’s conversion of EBIT to free cash flow should signal that it won’t have too many debt problems. But the other factors we noted above weren’t so encouraging. To be precise, he seems about as good at covering his interest costs with his EBIT as wet socks are at keeping your feet warm. Given this range of data points, we believe Prism Johnson is in a good position to manage its level of leverage. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 1 warning sign we spotted with Prism Johnson.
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.