Mangalore Chemicals & Fertilizers (NSE:MANGCHEFER) 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Mangalore Chemicals & Fertilizers Limited (NSE:MANGCHEFER) 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?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Mangalore Chemicals & Fertilizers

What Is Mangalore Chemicals & Fertilizers's Debt?

You can click the graphic below for the historical numbers, but it shows that Mangalore Chemicals & Fertilizers had ₹8.98b of debt in September 2021, down from ₹10.7b, one year before. However, because it has a cash reserve of ₹2.89b, its net debt is less, at about ₹6.10b.

How Strong Is Mangalore Chemicals & Fertilizers' Balance Sheet?

We can see from the most recent balance sheet that Mangalore Chemicals & Fertilizers had liabilities of ₹12.9b falling due within a year, and liabilities of ₹2.08b due beyond that. Offsetting this, it had ₹2.89b in cash and ₹6.99b in receivables that were due within 12 months. So it has liabilities totalling ₹5.05b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹8.00b, so it does suggest shareholders should keep an eye on Mangalore Chemicals & Fertilizers' 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.

Mangalore Chemicals & Fertilizers's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 11.8 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably Mangalore Chemicals & Fertilizers's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. 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 Mangalore Chemicals & Fertilizers will need earnings to service that debt. 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, Mangalore Chemicals & Fertilizers actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Mangalore Chemicals & Fertilizers's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Mangalore Chemicals & Fertilizers is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Mangalore Chemicals & Fertilizers that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.