David Iben put it well when he said: “Volatility is not a risk we care about. What matters to us is to avoid the permanent loss of capital. ‘ So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Above all, Tata Motors Limited (NSE: TATAMTRDVR) carries a debt. But the real question is whether this debt makes the business risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we look at debt levels, we first consider both liquidity and debt levels.
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What is the debt of Tata Motors?
The image below, which you can click for more details, shows that in March 2021 Tata Motors had a debt of 1.46 t, up from 1.06 t in a year. However, he has 659.2 billion yen in cash offsetting this, which leads to net debt of around 798.3 billion yen.
A look at the responsibilities of Tata Motors
According to the latest published balance sheet, Tata Motors had a liability of 1.58 t yen due within 12 months and a liability of 1.29 t yen due beyond 12 months. On the other hand, he had 659.2 billion yen in cash and 193.4 billion yen in receivables due within one year. Its liabilities therefore total 2.01 more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the society of 1.10, like a towering colossus of mere mortals. So we would be watching its record closely, without a doubt. Ultimately, Tata Motors would likely need a major recapitalization if its creditors demanded repayment.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.
While we’re not worried about Tata Motors’ 3.3 net debt to EBITDA ratio, we do think its ultra-low 1.8 times interest coverage is a sign of high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. A buyout factor for Tata Motors is that it turned last year’s EBIT loss into a gain of 129 billion yen, in the past twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine Tata Motors’ ability to maintain a healthy balance sheet going forward. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. In the most recent year, Tata Motors recorded free cash flow of 68% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
At first glance, Tata Motors’ interest hedging left us hesitant about the stock, and its total liability level was no more appealing than the only empty restaurant on the busiest night of the year. But at least it’s pretty decent to convert EBIT into free cash flow; it’s encouraging. Looking at the big picture, it seems clear to us that Tata Motors’ use of debt creates risks for the company. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we have identified 1 warning sign for Tata Motors that you need to be aware of.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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