Is Servotech Power Systems (NSE:SERVOTECH) Using Too Much Debt?

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.' 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 can see that Servotech Power Systems Limited (NSE:SERVOTECH) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Servotech Power Systems

How Much Debt Does Servotech Power Systems Carry?

The image below, which you can click on for greater detail, shows that at September 2022 Servotech Power Systems had debt of ₹244.2m, up from ₹187.9m in one year. On the flip side, it has ₹30.2m in cash leading to net debt of about ₹214.1m.

How Strong Is Servotech Power Systems' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Servotech Power Systems had liabilities of ₹451.8m due within 12 months and liabilities of ₹86.0m due beyond that. Offsetting these obligations, it had cash of ₹30.2m as well as receivables valued at ₹334.1m due within 12 months. So its liabilities total ₹173.5m more than the combination of its cash and short-term receivables.

Since publicly traded Servotech Power Systems shares are worth a total of ₹2.91b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Servotech Power Systems's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 2.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Servotech Power Systems saw its EBIT tank 33% over the last 12 months. 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 you can't view debt in total isolation; since Servotech Power Systems 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, 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. In the last three years, Servotech Power Systems created free cash flow amounting to 7.3% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Servotech Power Systems's EBIT growth rate was disappointing. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Servotech Power Systems stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Servotech Power Systems is showing 6 warning signs in our investment analysis , and 2 of those shouldn't be ignored...

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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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.