Is Sunflag Iron and Steel (NSE:SUNFLAG) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Sunflag Iron and Steel Company Limited (NSE:SUNFLAG) does have debt on its balance sheet. 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. 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 Sunflag Iron and Steel

What Is Sunflag Iron and Steel's Net Debt?

As you can see below, Sunflag Iron and Steel had ₹5.18b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of ₹592.7m, its net debt is less, at about ₹4.59b.

How Healthy Is Sunflag Iron and Steel's Balance Sheet?

According to the last reported balance sheet, Sunflag Iron and Steel had liabilities of ₹10.3b due within 12 months, and liabilities of ₹4.88b due beyond 12 months. Offsetting this, it had ₹592.7m in cash and ₹4.46b in receivables that were due within 12 months. So its liabilities total ₹10.1b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sunflag Iron and Steel has a market capitalization of ₹19.4b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sunflag Iron and Steel has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.2 times, which is more than adequate. But the other side of the story is that Sunflag Iron and Steel saw its EBIT decline by 5.5% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Sunflag Iron and Steel 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Sunflag Iron and Steel recorded negative free cash flow, in total. 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

We'd go so far as to say Sunflag Iron and Steel's conversion of EBIT to free cash flow was disappointing. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sunflag Iron and Steel stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 1 warning sign for Sunflag Iron and Steel 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.