Here's Why Bharat Heavy Electricals (NSE:BHEL) Has A Meaningful Debt Burden

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.' 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. As with many other companies Bharat Heavy Electricals Limited (NSE:BHEL) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Bharat Heavy Electricals

How Much Debt Does Bharat Heavy Electricals Carry?

As you can see below, Bharat Heavy Electricals had ₹90.6b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₹51.0b in cash leading to net debt of about ₹39.6b.

A Look At Bharat Heavy Electricals' Liabilities

According to the last reported balance sheet, Bharat Heavy Electricals had liabilities of ₹269.7b due within 12 months, and liabilities of ₹106.3b due beyond 12 months. Offsetting these obligations, it had cash of ₹51.0b as well as receivables valued at ₹64.9b due within 12 months. So it has liabilities totalling ₹260.0b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Bharat Heavy Electricals has a huge market capitalization of ₹875.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Bharat Heavy Electricals's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 5.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Bharat Heavy Electricals made a loss at the EBIT level, last year, but improved that to positive EBIT of ₹7.1b in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Bharat Heavy Electricals 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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Bharat Heavy Electricals reported free cash flow worth 3.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Bharat Heavy Electricals's conversion of EBIT to free cash flow and its net debt to EBITDA were discouraging. At least its interest cover gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Bharat Heavy Electricals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Over time, share prices tend to follow earnings per share, so if you're interested in Bharat Heavy Electricals, you may well want to click here to check an interactive graph of its earnings per share history.

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.