Stock Analysis

Here's Why JSW Steel (NSE:JSWSTEEL) Can Manage Its Debt Responsibly

NSEI:JSWSTEEL
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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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that JSW Steel Limited (NSE:JSWSTEEL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for JSW Steel

What Is JSW Steel's Net Debt?

As you can see below, JSW Steel had ₹517.9b of debt at March 2021, down from ₹605.1b a year prior. On the flip side, it has ₹142.9b in cash leading to net debt of about ₹375.0b.

debt-equity-history-analysis
NSEI:JSWSTEEL Debt to Equity History June 25th 2021

A Look At JSW Steel's Liabilities

According to the last reported balance sheet, JSW Steel had liabilities of ₹433.0b due within 12 months, and liabilities of ₹588.7b due beyond 12 months. Offsetting this, it had ₹142.9b in cash and ₹51.1b in receivables that were due within 12 months. So it has liabilities totalling ₹827.7b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since JSW Steel has a huge market capitalization of ₹1.60t, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

JSW Steel's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that JSW Steel's EBIT shot up like bamboo after rain, gaining 82% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine JSW Steel's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, JSW Steel recorded free cash flow of 35% of its EBIT, which is weaker 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 JSW Steel was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about JSW Steel'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. 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 3 warning signs for JSW Steel you should know about.

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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