Here's Why Morgan Advanced Materials (LON:MGAM) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Morgan Advanced Materials plc (LON:MGAM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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

How Much Debt Does Morgan Advanced Materials Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Morgan Advanced Materials had debt of UK£346.0m, up from UK£197.9m in one year. However, it also had UK£137.5m in cash, and so its net debt is UK£208.5m.

A Look At Morgan Advanced Materials' Liabilities

According to the last reported balance sheet, Morgan Advanced Materials had liabilities of UK£280.0m due within 12 months, and liabilities of UK£377.2m due beyond 12 months. Offsetting these obligations, it had cash of UK£137.5m as well as receivables valued at UK£228.2m due within 12 months. So its liabilities total UK£291.5m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Morgan Advanced Materials is worth UK£790.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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 a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 12.3 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Morgan Advanced Materials saw its EBIT decline by 6.5% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Morgan Advanced Materials 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

Neither Morgan Advanced Materials's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Morgan Advanced Materials is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 3 warning signs for Morgan Advanced Materials (2 are significant!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.