These 4 Measures Indicate That Elecon Engineering (NSE:ELECON) Is Using Debt Safely

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Elecon Engineering Company Limited (NSE:ELECON) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Elecon Engineering

What Is Elecon Engineering's Net Debt?

As you can see below, Elecon Engineering had ₹2.43b of debt at September 2021, down from ₹4.05b a year prior. On the flip side, it has ₹1.47b in cash leading to net debt of about ₹961.6m.

A Look At Elecon Engineering's Liabilities

We can see from the most recent balance sheet that Elecon Engineering had liabilities of ₹7.44b falling due within a year, and liabilities of ₹1.36b due beyond that. On the other hand, it had cash of ₹1.47b and ₹4.83b worth of receivables due within a year. So it has liabilities totalling ₹2.50b more than its cash and near-term receivables, combined.

Of course, Elecon Engineering has a market capitalization of ₹16.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 Elecon Engineering's low debt to EBITDA ratio of 0.39 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.9 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, Elecon Engineering is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 123% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Elecon Engineering will need earnings to service that debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Elecon Engineering actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Elecon Engineering's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that Elecon Engineering is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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. We've identified 1 warning sign with Elecon Engineering , and understanding them should be part of your investment process.

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.