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.' 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. We note that JSW Steel Limited (NSE:JSWSTEEL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is JSW Steel's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 JSW Steel had ₹481.2b of debt, an increase on ₹412.3b, over one year. On the flip side, it has ₹102.8b in cash leading to net debt of about ₹378.4b.
How Strong Is JSW Steel's Balance Sheet?
The latest balance sheet data shows that JSW Steel had liabilities of ₹406.1b due within a year, and liabilities of ₹505.2b falling due after that. On the other hand, it had cash of ₹102.8b and ₹44.1b worth of receivables due within a year. So its liabilities total ₹764.4b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of ₹871.2b, so it does suggest shareholders should keep an eye on JSW Steel's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While JSW Steel's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, JSW Steel's EBIT was down 36% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, JSW Steel 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.
Mulling over JSW Steel's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Overall, it seems to us that JSW Steel's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 6 warning signs for JSW Steel (1 shouldn't be ignored!) that you should be aware of before investing here.
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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