We Think Sheela Foam (NSE:SFL) Can Stay On Top Of Its Debt

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. As with many other companies Sheela Foam Limited (NSE:SFL) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 2020, Sheela Foam had ₹1.85b of debt, up from ₹288.8m a year ago. Click the image for more detail. However, it does have ₹2.93b in cash offsetting this, leading to net cash of ₹1.08b.

How Healthy Is Sheela Foam's Balance Sheet?

We can see from the most recent balance sheet that Sheela Foam had liabilities of ₹4.51b falling due within a year, and liabilities of ₹3.40b due beyond that. Offsetting these obligations, it had cash of ₹2.93b as well as receivables valued at ₹2.47b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.50b.

Since publicly traded Sheela Foam shares are worth a total of ₹87.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Sheela Foam also has more cash than debt, so we're pretty confident it can manage its debt safely.

The good news is that Sheela Foam has increased its EBIT by 8.1% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sheela Foam has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Sheela Foam produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Sheela Foam has ₹1.08b in net cash. On top of that, it increased its EBIT by 8.1% in the last twelve months. So we don't think Sheela Foam's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Sheela Foam , and understanding them should be part of your investment process.

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. 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.
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