Here's Why Sheela Foam (NSE:SFL) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Sheela Foam Limited (NSE:SFL) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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 Sheela Foam

How Much Debt Does Sheela Foam Carry?

As you can see below, at the end of September 2022, Sheela Foam had ₹4.92b of debt, up from ₹3.28b a year ago. Click the image for more detail. On the flip side, it has ₹2.71b in cash leading to net debt of about ₹2.21b.

How Strong Is Sheela Foam's Balance Sheet?

We can see from the most recent balance sheet that Sheela Foam had liabilities of ₹5.26b falling due within a year, and liabilities of ₹4.23b due beyond that. Offsetting this, it had ₹2.71b in cash and ₹2.74b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹4.04b.

Given Sheela Foam has a market capitalization of ₹101.4b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Sheela Foam has net debt of just 0.81 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On the other hand, Sheela Foam's EBIT dived 16%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sheela Foam can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Sheela Foam's free cash flow amounted to 22% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Sheela Foam was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Sheela Foam's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in Sheela Foam, you may well want to click here to check an interactive graph of its earnings per share history.

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.