Here's Why Elgi Equipments (NSE:ELGIEQUIP) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Elgi Equipments Limited (NSE:ELGIEQUIP) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Elgi Equipments

How Much Debt Does Elgi Equipments Carry?

As you can see below, at the end of March 2023, Elgi Equipments had ₹5.77b of debt, up from ₹4.37b a year ago. Click the image for more detail. However, because it has a cash reserve of ₹5.68b, its net debt is less, at about ₹90.9m.

How Healthy Is Elgi Equipments' Balance Sheet?

The latest balance sheet data shows that Elgi Equipments had liabilities of ₹10.2b due within a year, and liabilities of ₹1.09b falling due after that. Offsetting these obligations, it had cash of ₹5.68b as well as receivables valued at ₹5.65b due within 12 months. So these liquid assets roughly match the total liabilities.

This state of affairs indicates that Elgi Equipments' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the ₹162.4b company is short on cash, but still worth keeping an eye on the 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).

With debt at a measly 0.021 times EBITDA and EBIT covering interest a whopping 3k times, it's clear that Elgi Equipments is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In addition to that, we're happy to report that Elgi Equipments has boosted its EBIT by 39%, 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Elgi Equipments's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Elgi Equipments's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think Elgi Equipments's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Be aware that Elgi Equipments is showing 1 warning sign in our investment analysis , you should know about...

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.

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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.