These 4 Measures Indicate That Morgan Advanced Materials (LON:MGAM) Is Using Debt Reasonably Well

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. We can see that Morgan Advanced Materials plc (LON:MGAM) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Morgan Advanced Materials

What Is Morgan Advanced Materials's Debt?

The image below, which you can click on for greater detail, shows that Morgan Advanced Materials had debt of UK£172.8m at the end of June 2021, a reduction from UK£271.0m over a year. However, it also had UK£107.6m in cash, and so its net debt is UK£65.2m.

How Healthy Is Morgan Advanced Materials' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Morgan Advanced Materials had liabilities of UK£221.7m due within 12 months and liabilities of UK£357.8m due beyond that. Offsetting this, it had UK£107.6m in cash and UK£161.7m in receivables that were due within 12 months. So it has liabilities totalling UK£310.2m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Morgan Advanced Materials has a market capitalization of UK£1.01b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Morgan Advanced Materials's net debt is only 0.52 times its EBITDA. And its EBIT covers its interest expense a whopping 11.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Morgan Advanced Materials has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Morgan Advanced Materials produced sturdy free cash flow equating to 65% 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 interest cover was a real positive on this analysis, as was its net debt to EBITDA. But truth be told its EBIT growth rate had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Morgan Advanced Materials is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Morgan Advanced Materials .

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.

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.

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