Is Morgan Advanced Materials (LON:MGAM) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Morgan Advanced Materials plc (LON:MGAM) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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, Morgan Advanced Materials had UK£248.8m of debt at December 2020, down from UK£290.1m a year prior. However, it does have UK£147.8m in cash offsetting this, leading to net debt of about UK£101.0m.

A Look At Morgan Advanced Materials' Liabilities

We can see from the most recent balance sheet that Morgan Advanced Materials had liabilities of UK£279.7m falling due within a year, and liabilities of UK£410.8m due beyond that. On the other hand, it had cash of UK£147.8m and UK£145.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£397.5m.

This deficit isn't so bad because Morgan Advanced Materials is worth UK£830.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Morgan Advanced Materials has net debt of just 0.84 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.1 times, which is more than adequate. The modesty of its debt load may become crucial for Morgan Advanced Materials if management cannot prevent a repeat of the 31% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Morgan Advanced Materials produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Morgan Advanced Materials's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. We think that Morgan Advanced Materials's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Morgan Advanced Materials has 2 warning signs (and 1 which is a bit unpleasant) we think 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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