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 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. Importantly, Steel Authority of India Limited (NSE:SAIL) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Steel Authority of India’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2020 Steel Authority of India had debt of ₹497.4b, up from ₹437.1b in one year. However, it does have ₹26.3b in cash offsetting this, leading to net debt of about ₹471.1b.
How Healthy Is Steel Authority of India’s Balance Sheet?
According to the last reported balance sheet, Steel Authority of India had liabilities of ₹449.6b due within 12 months, and liabilities of ₹404.5b due beyond 12 months. Offsetting this, it had ₹26.3b in cash and ₹88.9b in receivables that were due within 12 months. So it has liabilities totalling ₹738.9b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the ₹152.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Steel Authority of India would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Steel Authority of India’s debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, one redeeming factor is that Steel Authority of India grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Steel Authority of India can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Steel Authority of India recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On the face of it, Steel Authority of India’s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Taking into account all the aforementioned factors, it looks like Steel Authority of India has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. 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. Be aware that Steel Authority of India is showing 4 warning signs in our investment analysis , and 2 of those are potentially serious…
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. 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.
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