Is Sunflag Iron and Steel (NSE:SUNFLAG) A Risky Investment?

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 can see that Sunflag Iron and Steel Company Limited (NSE:SUNFLAG) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sunflag Iron and Steel

What Is Sunflag Iron and Steel's Debt?

As you can see below, Sunflag Iron and Steel had ₹5.49b of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₹1.18b in cash leading to net debt of about ₹4.31b.

A Look At Sunflag Iron and Steel's Liabilities

According to the last reported balance sheet, Sunflag Iron and Steel had liabilities of ₹8.87b due within 12 months, and liabilities of ₹7.11b due beyond 12 months. Offsetting these obligations, it had cash of ₹1.18b as well as receivables valued at ₹3.15b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹11.6b.

This deficit isn't so bad because Sunflag Iron and Steel is worth ₹43.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 Sunflag Iron and Steel's low debt to EBITDA ratio of 0.97 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way Sunflag Iron and Steel could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sunflag Iron and Steel's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Sunflag Iron and Steel 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

Sunflag Iron and Steel's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. We think that Sunflag Iron and Steel's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For instance, we've identified 2 warning signs for Sunflag Iron and Steel (1 is a bit concerning) 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.