Servotech Power Systems (NSE:SERVOTECH) Has A Pretty Healthy Balance Sheet

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. Importantly, Servotech Power Systems Limited (NSE:SERVOTECH) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Servotech Power Systems

What Is Servotech Power Systems's Debt?

As you can see below, Servotech Power Systems had ₹192.1m of debt at March 2022, down from ₹251.5m a year prior. On the flip side, it has ₹79.6m in cash leading to net debt of about ₹112.5m.

How Strong Is Servotech Power Systems' Balance Sheet?

The latest balance sheet data shows that Servotech Power Systems had liabilities of ₹341.2m due within a year, and liabilities of ₹90.0m falling due after that. Offsetting these obligations, it had cash of ₹79.6m as well as receivables valued at ₹357.9m due within 12 months. So these liquid assets roughly match the total liabilities.

This state of affairs indicates that Servotech Power Systems' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the ₹1.33b company is short on cash, but still worth keeping an eye on the balance sheet.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Servotech Power Systems's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Servotech Power Systems grew its EBIT by 98% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Servotech Power Systems's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Looking at the most recent three years, Servotech Power Systems recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Servotech Power Systems'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 interest cover. All these things considered, it appears that Servotech Power Systems 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. 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. For example, we've discovered 3 warning signs for Servotech Power Systems (1 is potentially serious!) that you should be aware of before investing here.

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.