Here's Why Bharat Forge (NSE:BHARATFORG) Has A Meaningful Debt Burden

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Bharat Forge Limited (NSE:BHARATFORG) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Bharat Forge

What Is Bharat Forge's Net Debt?

As you can see below, at the end of September 2022, Bharat Forge had ₹65.0b of debt, up from ₹57.1b a year ago. Click the image for more detail. On the flip side, it has ₹18.0b in cash leading to net debt of about ₹47.0b.

How Healthy Is Bharat Forge's Balance Sheet?

The latest balance sheet data shows that Bharat Forge had liabilities of ₹68.9b due within a year, and liabilities of ₹28.9b falling due after that. On the other hand, it had cash of ₹18.0b and ₹25.2b worth of receivables due within a year. So its liabilities total ₹54.6b more than the combination of its cash and short-term receivables.

Of course, Bharat Forge has a market capitalization of ₹388.2b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Bharat Forge's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 4.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably Bharat Forge's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Bharat Forge's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Bharat Forge saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Bharat Forge's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to handle its total liabilities isn't too shabby at all. When we consider all the factors discussed, it seems to us that Bharat Forge is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 instance, we've identified 3 warning signs for Bharat Forge (1 shouldn't be ignored) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.