We Think S.A.L. Steel (NSE:SALSTEEL) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that S.A.L. Steel Limited (NSE:SALSTEEL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for S.A.L. Steel

What Is S.A.L. Steel's Debt?

You can click the graphic below for the historical numbers, but it shows that S.A.L. Steel had ₹1.46b of debt in March 2020, down from ₹1.71b, one year before. Net debt is about the same, since the it doesn't have much cash.

How Strong Is S.A.L. Steel's Balance Sheet?

We can see from the most recent balance sheet that S.A.L. Steel had liabilities of ₹1.30b falling due within a year, and liabilities of ₹1.69b due beyond that. Offsetting this, it had ₹6.20m in cash and ₹1.20b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.8b.

The deficiency here weighs heavily on the ₹237.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, S.A.L. Steel would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Strangely S.A.L. Steel has a sky high EBITDA ratio of 5.6, implying high debt, but a strong interest coverage of 12.3. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, S.A.L. Steel's EBIT launched higher than Elon Musk, gaining a whopping 968% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since S.A.L. Steel will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, S.A.L. Steel reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both S.A.L. Steel's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that S.A.L. Steel's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Be aware that S.A.L. Steel is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

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.

If you’re looking to trade S.A.L. Steel, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.