Is Isgec Heavy Engineering (NSE:ISGEC) Using Too Much Debt?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Isgec Heavy Engineering Limited (NSE:ISGEC) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Isgec Heavy Engineering

What Is Isgec Heavy Engineering's Debt?

You can click the graphic below for the historical numbers, but it shows that Isgec Heavy Engineering had ₹9.33b of debt in September 2023, down from ₹11.8b, one year before. However, it also had ₹3.87b in cash, and so its net debt is ₹5.46b.

How Healthy Is Isgec Heavy Engineering's Balance Sheet?

We can see from the most recent balance sheet that Isgec Heavy Engineering had liabilities of ₹40.2b falling due within a year, and liabilities of ₹8.71b due beyond that. On the other hand, it had cash of ₹3.87b and ₹25.7b worth of receivables due within a year. So its liabilities total ₹19.4b more than the combination of its cash and short-term receivables.

Isgec Heavy Engineering has a market capitalization of ₹76.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Isgec Heavy Engineering has net debt of just 1.00 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.1 times, which is more than adequate. On top of that, Isgec Heavy Engineering grew its EBIT by 62% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Isgec Heavy Engineering's ability to maintain a healthy balance sheet going forward. 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 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. Looking at the most recent three years, Isgec Heavy Engineering recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Isgec Heavy Engineering's impressive EBIT growth rate implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Isgec Heavy Engineering can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 1 warning sign for Isgec Heavy Engineering you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.