Menon Bearings (NSE:MENONBE) Seems To Use Debt Quite Sensibly

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.' 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. Importantly, Menon Bearings Limited (NSE:MENONBE) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Menon Bearings

How Much Debt Does Menon Bearings Carry?

The image below, which you can click on for greater detail, shows that Menon Bearings had debt of ₹317.1m at the end of September 2020, a reduction from ₹412.2m over a year. However, it also had ₹100.8m in cash, and so its net debt is ₹216.3m.

How Strong Is Menon Bearings' Balance Sheet?

We can see from the most recent balance sheet that Menon Bearings had liabilities of ₹381.6m falling due within a year, and liabilities of ₹200.9m due beyond that. Offsetting these obligations, it had cash of ₹100.8m as well as receivables valued at ₹422.3m due within 12 months. So it has liabilities totalling ₹59.3m more than its cash and near-term receivables, combined.

This state of affairs indicates that Menon Bearings' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the ₹3.10b company is short on cash, but still worth keeping an eye on the balance sheet.

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.

With net debt sitting at just 0.70 times EBITDA, Menon Bearings is arguably pretty conservatively geared. And it boasts interest cover of 9.4 times, which is more than adequate. But the bad news is that Menon Bearings has seen its EBIT plunge 10% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Menon Bearings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Menon Bearings created free cash flow amounting to 6.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Menon Bearings's net debt to EBITDA was a real positive on this analysis, as was its interest cover. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Menon Bearings's use of debt. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Menon Bearings is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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