Somi Conveyor Beltings (NSE:SOMICONVEY) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Somi Conveyor Beltings Limited (NSE:SOMICONVEY) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Somi Conveyor Beltings

What Is Somi Conveyor Beltings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Somi Conveyor Beltings had ₹176.0m of debt in March 2023, down from ₹283.4m, one year before. On the flip side, it has ₹57.8m in cash leading to net debt of about ₹118.3m.

A Look At Somi Conveyor Beltings' Liabilities

According to the last reported balance sheet, Somi Conveyor Beltings had liabilities of ₹325.8m due within 12 months, and liabilities of ₹36.7m due beyond 12 months. Offsetting these obligations, it had cash of ₹57.8m as well as receivables valued at ₹293.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹11.4m.

This state of affairs indicates that Somi Conveyor Beltings' 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 ₹727.3m company is struggling for cash, we still think it's worth monitoring its balance sheet.

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.

Somi Conveyor Beltings has net debt worth 1.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.5 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Also relevant is that Somi Conveyor Beltings has grown its EBIT by a very respectable 24% in the last year, thus enhancing its ability to pay down 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, 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. During the last three years, Somi Conveyor Beltings produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Somi Conveyor Beltings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its interest cover. Zooming out, Somi Conveyor Beltings seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. Be aware that Somi Conveyor Beltings is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.