Does Somi Conveyor Beltings (NSE:SOMICONVEY) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Somi Conveyor Beltings Limited (NSE:SOMICONVEY) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Somi Conveyor Beltings

What Is Somi Conveyor Beltings's Net Debt?

The image below, which you can click on for greater detail, shows that Somi Conveyor Beltings had debt of ₹210.3m at the end of September 2022, a reduction from ₹239.6m over a year. However, it does have ₹29.6m in cash offsetting this, leading to net debt of about ₹180.8m.

How Strong Is Somi Conveyor Beltings' Balance Sheet?

We can see from the most recent balance sheet that Somi Conveyor Beltings had liabilities of ₹300.2m falling due within a year, and liabilities of ₹38.6m due beyond that. On the other hand, it had cash of ₹29.6m and ₹152.4m worth of receivables due within a year. So it has liabilities totalling ₹156.8m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Somi Conveyor Beltings has a market capitalization of ₹408.8m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Somi Conveyor Beltings's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a slightly more positive note, Somi Conveyor Beltings grew its EBIT at 16% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Somi Conveyor Beltings'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.

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 three years, Somi Conveyor Beltings reported free cash flow worth 8.7% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Somi Conveyor Beltings's conversion of EBIT to free cash flow and its interest cover were discouraging. But its not so bad at growing its EBIT. We think that Somi Conveyor Beltings's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example - Somi Conveyor Beltings has 1 warning sign we think 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.