Sona BLW Precision Forgings (NSE:SONACOMS) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that Sona BLW Precision Forgings Limited (NSE:SONACOMS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sona BLW Precision Forgings

What Is Sona BLW Precision Forgings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Sona BLW Precision Forgings had ₹3.86b of debt, an increase on ₹2.55b, over one year. However, it does have ₹2.44b in cash offsetting this, leading to net debt of about ₹1.42b.

How Healthy Is Sona BLW Precision Forgings' Balance Sheet?

We can see from the most recent balance sheet that Sona BLW Precision Forgings had liabilities of ₹7.10b falling due within a year, and liabilities of ₹3.08b due beyond that. Offsetting this, it had ₹2.44b in cash and ₹6.76b in receivables that were due within 12 months. So its liabilities total ₹991.0m more than the combination of its cash and short-term receivables.

Having regard to Sona BLW Precision Forgings' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the ₹380.7b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Sona BLW Precision Forgings has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sona BLW Precision Forgings has a low net debt to EBITDA ratio of only 0.17. And its EBIT covers its interest expense a whopping 37.1 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Sona BLW Precision Forgings grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sona BLW Precision Forgings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sona BLW Precision Forgings's free cash flow amounted to 32% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Sona BLW Precision Forgings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think Sona BLW Precision Forgings's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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 1 warning sign for Sona BLW Precision Forgings that you should be aware of.

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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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.