These 4 Measures Indicate That Varroc Engineering (NSE:VARROC) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Varroc Engineering Limited (NSE:VARROC) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

Check out our latest analysis for Varroc Engineering

What Is Varroc Engineering's Net Debt?

The image below, which you can click on for greater detail, shows that Varroc Engineering had debt of ₹12.1b at the end of March 2024, a reduction from ₹16.4b over a year. However, it does have ₹2.27b in cash offsetting this, leading to net debt of about ₹9.83b.

How Strong Is Varroc Engineering's Balance Sheet?

We can see from the most recent balance sheet that Varroc Engineering had liabilities of ₹21.6b falling due within a year, and liabilities of ₹8.76b due beyond that. Offsetting these obligations, it had cash of ₹2.27b as well as receivables valued at ₹4.92b due within 12 months. So its liabilities total ₹23.2b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Varroc Engineering is worth ₹92.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Varroc Engineering's EBIT has low interest coverage of 2.3 times. So one way or the other, it's clear the debt levels are not trivial. Importantly, Varroc Engineering grew its EBIT by 68% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Varroc Engineering'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Varroc Engineering's free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for Varroc Engineering was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. Considering this range of data points, we think Varroc Engineering is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example - Varroc Engineering has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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