Does Morgan Advanced Materials (LON:MGAM) Have A Healthy Balance Sheet?

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. Importantly, Morgan Advanced Materials plc (LON:MGAM) does carry 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Morgan Advanced Materials

What Is Morgan Advanced Materials's Net Debt?

As you can see below, at the end of December 2022, Morgan Advanced Materials had UK£266.2m of debt, up from UK£174.0m a year ago. Click the image for more detail. However, it does have UK£117.7m in cash offsetting this, leading to net debt of about UK£148.5m.

A Look At Morgan Advanced Materials' Liabilities

We can see from the most recent balance sheet that Morgan Advanced Materials had liabilities of UK£283.4m falling due within a year, and liabilities of UK£307.3m due beyond that. Offsetting this, it had UK£117.7m in cash and UK£188.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£285.0m.

While this might seem like a lot, it is not so bad since Morgan Advanced Materials has a market capitalization of UK£788.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Morgan Advanced Materials has a low net debt to EBITDA ratio of only 0.84. And its EBIT easily covers its interest expense, being 18.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Morgan Advanced Materials grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Morgan Advanced Materials can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Morgan Advanced Materials recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Morgan Advanced Materials's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Morgan Advanced Materials can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Morgan Advanced Materials (at least 1 which is concerning) , 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.