We Think GAIL (India) (NSE:GAIL) Can Stay On Top Of Its Debt
Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies GAIL (India) Limited (NSE:GAIL) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is GAIL (India)’s Net Debt?
As you can see below, at the end of March 2022, GAIL (India) had ₹78.3b of debt, up from ₹72.1b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹28.0b, its net debt is less, at about ₹50.3b.
How Healthy Is GAIL (India)’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that GAIL (India) had liabilities of ₹150.9b due within 12 months and liabilities of ₹171.6b due beyond that. Offsetting these obligations, it had cash of ₹28.0b as well as receivables valued at ₹75.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹219.0b.
This deficit isn’t so bad because GAIL (India) is worth ₹609.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
GAIL (India)’s net debt is only 0.33 times its EBITDA. And its EBIT covers its interest expense a whopping 62.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that GAIL (India) grew its EBIT by 142% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 GAIL (India)’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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, GAIL (India) reported free cash flow worth 20% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
The good news is that GAIL (India)’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. It’s also worth noting that GAIL (India) is in the Gas Utilities industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that GAIL (India) takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example GAIL (India) has 2 warning signs (and 1 which is concerning) we think you should know about.