Sunflag Iron and Steel (NSE:SUNFLAG) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Sunflag Iron and Steel Company Limited (NSE:SUNFLAG) does carry debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sunflag Iron and Steel

What Is Sunflag Iron and Steel's Debt?

You can click the graphic below for the historical numbers, but it shows that Sunflag Iron and Steel had ₹5.49b of debt in September 2024, down from ₹7.72b, one year before. On the flip side, it has ₹1.13b in cash leading to net debt of about ₹4.36b.

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

According to the last reported balance sheet, Sunflag Iron and Steel had liabilities of ₹9.09b due within 12 months, and liabilities of ₹11.2b due beyond 12 months. On the other hand, it had cash of ₹1.13b and ₹3.65b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹15.5b.

Sunflag Iron and Steel has a market capitalization of ₹46.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Looking at its net debt to EBITDA of 1.2 and interest cover of 4.1 times, it seems to us that Sunflag Iron and Steel is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The bad news is that Sunflag Iron and Steel saw its EBIT decline by 13% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Sunflag Iron and Steel's free cash flow amounted to 25% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Sunflag Iron and Steel's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. Taking the abovementioned factors together we do think Sunflag Iron and Steel'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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Sunflag Iron and Steel .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.