Is Nelcast (NSE:NELCAST) A Risky Investment?

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. Importantly, Nelcast Limited (NSE:NELCAST) does carry debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Nelcast

What Is Nelcast's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Nelcast had ₹2.60b of debt, an increase on ₹2.28b, over one year. However, it also had ₹531.7m in cash, and so its net debt is ₹2.07b.

How Healthy Is Nelcast's Balance Sheet?

The latest balance sheet data shows that Nelcast had liabilities of ₹3.06b due within a year, and liabilities of ₹1.60b falling due after that. On the other hand, it had cash of ₹531.7m and ₹2.04b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.09b.

While this might seem like a lot, it is not so bad since Nelcast has a market capitalization of ₹7.13b, 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.

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.

While we wouldn't worry about Nelcast's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 2.2 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that Nelcast actually grew its EBIT by a hefty 167%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Nelcast 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Nelcast burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Nelcast's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Nelcast's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 instance, we've identified 4 warning signs for Nelcast (2 can't be ignored) 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. 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.