Is Kirloskar Ferrous Industries (NSE:KIRLFER) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Kirloskar Ferrous Industries Limited (NSE:KIRLFER) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Kirloskar Ferrous Industries

What Is Kirloskar Ferrous Industries's Debt?

As you can see below, Kirloskar Ferrous Industries had ₹1.95b of debt at September 2020, down from ₹2.11b a year prior. However, it also had ₹302.1m in cash, and so its net debt is ₹1.65b.

How Strong Is Kirloskar Ferrous Industries' Balance Sheet?

According to the last reported balance sheet, Kirloskar Ferrous Industries had liabilities of ₹5.24b due within 12 months, and liabilities of ₹2.55b due beyond 12 months. Offsetting these obligations, it had cash of ₹302.1m as well as receivables valued at ₹2.77b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹4.72b.

Kirloskar Ferrous Industries has a market capitalization of ₹20.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Kirloskar Ferrous Industries has a low net debt to EBITDA ratio of only 0.47. 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. In addition to that, we're happy to report that Kirloskar Ferrous Industries has boosted its EBIT by 98%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Kirloskar Ferrous Industries will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Kirloskar Ferrous Industries actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Kirloskar Ferrous Industries's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Kirloskar Ferrous Industries can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Kirloskar Ferrous Industries , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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