Debt and solvency

Chapter 10 showed debt multiplying returns. This chapter is about what it does when things go the other way.

Measure it against cash flow

The common instinct is to compare debt with assets — the company owes ₹2,000 crore and owns ₹8,000 crore of assets, so it is fine.

That is the wrong comparison, because lenders are not repaid in assets. They are repaid in cash, on dates. A company with valuable assets and insufficient cash flow defaults; the assets are then sold under pressure for less than their carrying value, which is why the asset comparison is doubly misleading.

Two ratios, and they answer different questions.

Net debt to EBITDA = (borrowings − cash) ÷ EBITDA.

Roughly how many years of operating earnings the debt represents. Below 1 is conservative; 2–3 is ordinary for a stable business; above 4 is high and depends entirely on how steady the earnings are.

Interest cover = operating profit ÷ finance costs.

How many times over the company can pay its interest from operations. This is the more immediate measure, because interest is due regardless. Below about 3 deserves attention. Below 2 means a moderate downturn stops the payments being comfortable.

The question underneath both

How steady are the earnings that service this?

A regulated utility with contracted revenue can carry debt that would destroy a cyclical commodity producer. The same net debt to EBITDA means different things in the two cases, and the difference is the variability of the denominator.

So the honest sequence: look at EBITDA across five years including a bad one, then ask whether the debt is serviceable at the worst of those, not the average.

The maturity profile matters as much as the total

A fact the headline figure conceals, and the notes disclose.

₹2,000 crore of debt maturing evenly over ten years is a manageable obligation. The same ₹2,000 crore all maturing next year is a refinancing event — the company must persuade lenders to lend again, on terms set by conditions at that moment rather than the ones when it borrowed.

Most corporate distress is a refinancing failure rather than an inability to pay interest. A company can be servicing its debt perfectly and still fail because a large maturity arrives when credit markets are closed.

Three things to look for in the borrowings note:

How much is due within twelve months, against cash and expected cash generation.

Whether it is fixed or floating. Floating-rate debt reprices when rates rise, so chapter 3 of the fixed income subject's seesaw arrives as a cost increase here.

Covenants. Conditions attached to the borrowing — maximum leverage, minimum interest cover. Breaching one can make debt immediately repayable, which turns a slow problem into an immediate one. Covenants are disclosed and almost never read.

Net debt, and when the cash is not really there

Netting cash against debt assumes the cash is available to repay it. Two situations where it is not.

Cash trapped in subsidiaries, particularly overseas, where moving it costs tax or is restricted.

Cash that is working capital, needed to run the business day to day rather than genuinely surplus.

For a company with large gross debt and large gross cash, look at both numbers, not just the difference.

Debt is not the enemy

Worth stating, because the chapter so far reads as a warning.

Debt is cheaper than equity and its interest is deductible. A business with stable cash flows that refuses all debt is leaving returns on the table, and chapter 10's multiplier is a legitimate tool.

What makes debt dangerous is the combination of a lot of it with variable earnings or a concentrated maturity. Any one of those is manageable. Two together is where failures come from.

The signals of stress

In rough order of how early they appear:

• Receivable and inventory days rising, from chapter 11
• Interest cover falling while debt is flat — the cost of borrowing is rising
• Operating cash flow consistently below profit, from chapter 6
• Short-term borrowings growing as a share of total debt
• Promoter shares pledged, from chapter 6 of the equity subject
• Auditor's qualification or a key audit matter on going concern, from chapter 7

None is conclusive alone. Three together is a pattern, and patterns in credit tend to continue.

The point

Debt is serviced from cash, so measure it against EBITDA and interest against operating profit — not against assets, which are sold cheaply under pressure. The maturity profile matters as much as the total, because most distress is a refinancing failure. A lot of debt is survivable; a lot of debt with variable earnings or a concentrated maturity is where failures come from.