Here's Why Indian Metals and Ferro Alloys (NSE:IMFA) Can Manage Its Debt Responsibly

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 note that Indian Metals and Ferro Alloys Limited (NSE:IMFA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Indian Metals and Ferro Alloys

What Is Indian Metals and Ferro Alloys's Net Debt?

The image below, which you can click on for greater detail, shows that Indian Metals and Ferro Alloys had debt of ₹4.76b at the end of March 2022, a reduction from ₹6.64b over a year. However, it does have ₹1.77b in cash offsetting this, leading to net debt of about ₹2.99b.

How Strong Is Indian Metals and Ferro Alloys' Balance Sheet?

The latest balance sheet data shows that Indian Metals and Ferro Alloys had liabilities of ₹8.58b due within a year, and liabilities of ₹2.18b falling due after that. Offsetting this, it had ₹1.77b in cash and ₹1.41b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹7.58b.

This deficit is considerable relative to its market capitalization of ₹12.5b, so it does suggest shareholders should keep an eye on Indian Metals and Ferro Alloys' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Indian Metals and Ferro Alloys has a low net debt to EBITDA ratio of only 0.37. And its EBIT covers its interest expense a whopping 13.2 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Indian Metals and Ferro Alloys grew its EBIT by 196% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Indian Metals and Ferro Alloys'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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Indian Metals and Ferro Alloys recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Indian Metals and Ferro Alloys's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Indian Metals and Ferro Alloys is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Indian Metals and Ferro Alloys you should know about.

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.