Elgi Equipments (NSE:ELGIEQUIP) Could Easily Take On More Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Elgi Equipments Limited (NSE:ELGIEQUIP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Elgi Equipments

What Is Elgi Equipments's Debt?

You can click the graphic below for the historical numbers, but it shows that Elgi Equipments had ₹3.71b of debt in March 2022, down from ₹4.01b, one year before. However, it does have ₹2.78b in cash offsetting this, leading to net debt of about ₹926.1m.

How Strong Is Elgi Equipments' Balance Sheet?

According to the last reported balance sheet, Elgi Equipments had liabilities of ₹8.06b due within 12 months, and liabilities of ₹1.26b due beyond 12 months. Offsetting these obligations, it had cash of ₹2.78b as well as receivables valued at ₹4.75b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.79b.

Having regard to Elgi Equipments' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the ₹116.9b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Elgi Equipments has a very light debt load indeed.

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).

Elgi Equipments has a low net debt to EBITDA ratio of only 0.32. And its EBIT covers its interest expense a whopping 19.6 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Elgi Equipments has boosted its EBIT by 78%, thus reducing the spectre of future debt repayments. 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 Elgi Equipments's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Elgi Equipments produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Elgi Equipments's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. 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 Elgi Equipments 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Elgi Equipments you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.