These 4 Measures Indicate That Azad Engineering (NSE:AZAD) 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. We note that Azad Engineering Limited (NSE:AZAD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Azad Engineering

What Is Azad Engineering's Debt?

You can click the graphic below for the historical numbers, but it shows that Azad Engineering had ₹1.48b of debt in September 2024, down from ₹3.27b, one year before. However, it does have ₹360.8m in cash offsetting this, leading to net debt of about ₹1.12b.

How Healthy Is Azad Engineering's Balance Sheet?

We can see from the most recent balance sheet that Azad Engineering had liabilities of ₹1.54b falling due within a year, and liabilities of ₹1.36b due beyond that. Offsetting these obligations, it had cash of ₹360.8m as well as receivables valued at ₹2.26b due within 12 months. So it has liabilities totalling ₹277.7m more than its cash and near-term receivables, combined.

This state of affairs indicates that Azad Engineering's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹100.5b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Azad Engineering has a very light debt load indeed.

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.

While Azad Engineering's low debt to EBITDA ratio of 0.82 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. In addition to that, we're happy to report that Azad Engineering has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Azad Engineering can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, Azad Engineering saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, Azad Engineering's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Azad Engineering can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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 instance, we've identified 1 warning sign for Azad Engineering that 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.

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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.