Is Sheela Foam (NSE:SFL) Using Too Much Debt?

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.' 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, Sheela Foam Limited (NSE:SFL) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sheela Foam

What Is Sheela Foam's Net Debt?

As you can see below, Sheela Foam had ₹2.06b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₹1.79b, its net debt is less, at about ₹270.8m.

How Healthy Is Sheela Foam's Balance Sheet?

According to the last reported balance sheet, Sheela Foam had liabilities of ₹5.42b due within 12 months, and liabilities of ₹3.41b due beyond 12 months. Offsetting this, it had ₹1.79b in cash and ₹3.08b in receivables that were due within 12 months. So it has liabilities totalling ₹3.96b more than its cash and near-term receivables, combined.

Of course, Sheela Foam has a market capitalization of ₹111.8b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Sheela Foam has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sheela Foam has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.075 and EBIT of 16.4 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Also good is that Sheela Foam grew its EBIT at 17% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sheela Foam's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Sheela Foam recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Sheela Foam's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Sheela Foam takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Sheela Foam insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

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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