Electrosteel Castings (NSE:ELECTCAST) Seems To Be Using A Lot 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.' 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. We note that Electrosteel Castings Limited (NSE:ELECTCAST) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Electrosteel Castings

What Is Electrosteel Castings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Electrosteel Castings had ₹22.3b of debt, an increase on ₹17.8b, over one year. On the flip side, it has ₹9.81b in cash leading to net debt of about ₹12.5b.

A Look At Electrosteel Castings's Liabilities

The latest balance sheet data shows that Electrosteel Castings had liabilities of ₹21.1b due within a year, and liabilities of ₹13.7b falling due after that. Offsetting these obligations, it had cash of ₹9.81b as well as receivables valued at ₹8.50b due within 12 months. So it has liabilities totalling ₹16.5b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₹9.94b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Electrosteel Castings would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Electrosteel Castings's debt to EBITDA ratio (4.3) suggests that it uses some debt, its interest cover is very weak, at 1.6, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Electrosteel Castings's EBIT was down 37% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Electrosteel Castings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Electrosteel Castings recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Electrosteel Castings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. After considering the datapoints discussed, we think Electrosteel Castings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Electrosteel Castings you should be aware of, and 2 of them are concerning.

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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