Indian Metals and Ferro Alloys (NSE:IMFA) 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. As with many other companies Indian Metals and Ferro Alloys Limited (NSE:IMFA) makes use of debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Indian Metals and Ferro Alloys

How Much Debt Does Indian Metals and Ferro Alloys Carry?

You can click the graphic below for the historical numbers, but it shows that Indian Metals and Ferro Alloys had ₹5.91b of debt in September 2020, down from ₹7.23b, one year before. However, it does have ₹2.01b in cash offsetting this, leading to net debt of about ₹3.90b.

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

According to the last reported balance sheet, Indian Metals and Ferro Alloys had liabilities of ₹7.33b due within 12 months, and liabilities of ₹5.57b due beyond 12 months. On the other hand, it had cash of ₹2.01b and ₹562.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹10.3b.

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. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Even though Indian Metals and Ferro Alloys's debt is only 1.8, its interest cover is really very low at 1.5. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. It is well worth noting that Indian Metals and Ferro Alloys's EBIT shot up like bamboo after rain, gaining 62% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Indian Metals and Ferro Alloys actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Indian Metals and Ferro Alloys's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. Considering this range of data points, we think Indian Metals and Ferro Alloys is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Indian Metals and Ferro Alloys (1 is concerning) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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