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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Patel Engineering Limited (NSE:PATELENG) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Patel Engineering

The image below, which you can click on for greater detail, shows that Patel Engineering had debt of 21.8b at the end of September 2020, a reduction from 25.9b over a year. However, because it has a cash reserve of 2.08b, its net debt is less, at about 19.7b.

Zooming in on the latest balance sheet data, we can see that Patel Engineering had liabilities of 39.6b due within 12 months and liabilities of 15.2b due beyond that. Offsetting this, it had 2.08b in cash and 3.47b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by 49.2b.

This deficit casts a shadow over the 5.70b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Patel Engineering would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.11 times and a disturbingly high net debt to EBITDA ratio of 19.4 hit our confidence in Patel Engineering like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Patel Engineering saw its EBIT tank 90% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Patel Engineering'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 always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Patel Engineering actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

On the face of it, Patel Engineering's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Patel Engineering has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Patel Engineering , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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. *Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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These 4 Measures Indicate That Patel Engineering (NSE:PATELENG) Is Using Debt Extensively - Simply Wall St