Bharat Heavy Electricals (NSE:BHEL) Takes On Some Risk With Its Use Of Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Bharat Heavy Electricals Limited (NSE:BHEL) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Bharat Heavy Electricals

What Is Bharat Heavy Electricals's Net Debt?

As you can see below, Bharat Heavy Electricals had ₹91.3b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₹51.0b, its net debt is less, at about ₹40.2b.

How Strong Is Bharat Heavy Electricals' Balance Sheet?

We can see from the most recent balance sheet that Bharat Heavy Electricals had liabilities of ₹269.7b falling due within a year, and liabilities of ₹106.3b due beyond that. On the other hand, it had cash of ₹51.0b and ₹64.9b worth of receivables due within a year. So it has liabilities totalling ₹260.0b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Bharat Heavy Electricals is worth ₹674.1b, 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). 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).

Bharat Heavy Electricals's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 6.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We also note that Bharat Heavy Electricals improved its EBIT from a last year's loss to a positive ₹7.9b. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Bharat Heavy Electricals's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Bharat Heavy Electricals reported free cash flow worth 3.3% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While Bharat Heavy Electricals's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at covering its interest expense with its EBIT. Taking the abovementioned factors together we do think Bharat Heavy Electricals's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Bharat Heavy Electricals's earnings per share history for free.

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.