Lloyds Engineering Works (NSE:LSIL) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Lloyds Engineering Works Limited (NSE:LSIL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Lloyds Engineering Works

What Is Lloyds Engineering Works's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Lloyds Engineering Works had debt of ₹522.0m, up from ₹229.8m in one year. On the flip side, it has ₹79.9m in cash leading to net debt of about ₹442.2m.

How Strong Is Lloyds Engineering Works' Balance Sheet?

We can see from the most recent balance sheet that Lloyds Engineering Works had liabilities of ₹1.66b falling due within a year, and liabilities of ₹89.9m due beyond that. On the other hand, it had cash of ₹79.9m and ₹887.4m worth of receivables due within a year. So its liabilities total ₹787.6m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Lloyds Engineering Works' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹46.2b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Lloyds Engineering Works has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lloyds Engineering Works has a low debt to EBITDA ratio of only 0.83. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Better yet, Lloyds Engineering Works grew its EBIT by 179% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Lloyds Engineering Works will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last two years, Lloyds Engineering Works saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Lloyds Engineering Works's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Lloyds Engineering Works can comfortably handle its current debt levels. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Lloyds Engineering Works (at least 1 which is concerning) , and understanding them should be part of your investment process.

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.