We Think Sterling Tools (NSE:STERTOOLS) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Sterling Tools Limited (NSE:STERTOOLS) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sterling Tools

What Is Sterling Tools's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Sterling Tools had debt of ₹1.14b, up from ₹1.00b in one year. However, because it has a cash reserve of ₹365.7m, its net debt is less, at about ₹771.1m.

How Strong Is Sterling Tools' Balance Sheet?

According to the last reported balance sheet, Sterling Tools had liabilities of ₹1.47b due within 12 months, and liabilities of ₹669.6m due beyond 12 months. On the other hand, it had cash of ₹365.7m and ₹523.8m worth of receivables due within a year. So it has liabilities totalling ₹1.25b more than its cash and near-term receivables, combined.

Since publicly traded Sterling Tools shares are worth a total of ₹13.4b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sterling Tools has net debt of just 0.96 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.6 times the interest expense over the last year. The good news is that Sterling Tools has increased its EBIT by 6.0% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sterling Tools's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sterling Tools burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen Sterling Tools is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we thought its interest cover was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Sterling Tools'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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Sterling Tools you should be aware of, and 1 of them can't be ignored.

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.

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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.