Here's Why Morgan Advanced Materials (LON:MGAM) Can Manage Its Debt Responsibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Morgan Advanced Materials plc (LON:MGAM) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Morgan Advanced Materials

What Is Morgan Advanced Materials's Debt?

The chart below, which you can click on for greater detail, shows that Morgan Advanced Materials had UK£338.9m in debt in June 2024; about the same as the year before. However, it also had UK£116.6m in cash, and so its net debt is UK£222.3m.

How Strong Is Morgan Advanced Materials' Balance Sheet?

The latest balance sheet data shows that Morgan Advanced Materials had liabilities of UK£232.2m due within a year, and liabilities of UK£409.9m falling due after that. Offsetting this, it had UK£116.6m in cash and UK£209.5m in receivables that were due within 12 months. So its liabilities total UK£316.0m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Morgan Advanced Materials has a market capitalization of UK£821.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Morgan Advanced Materials has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.3 times, which is more than adequate. Also good is that Morgan Advanced Materials grew its EBIT at 12% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Morgan Advanced Materials created free cash flow amounting to 2.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Morgan Advanced Materials's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its interest cover was a positive. Looking at all this data makes us feel a little cautious about Morgan Advanced Materials's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Morgan Advanced Materials is showing 2 warning signs in our investment analysis , you should know about...

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.