Is Vardhman Special Steels (NSE:VSSL) Using Too Much Debt?

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.' 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 Vardhman Special Steels Limited (NSE:VSSL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Vardhman Special Steels

How Much Debt Does Vardhman Special Steels Carry?

You can click the graphic below for the historical numbers, but it shows that Vardhman Special Steels had ₹1.70b of debt in March 2021, down from ₹2.65b, one year before. On the flip side, it has ₹629.5m in cash leading to net debt of about ₹1.07b.

A Look At Vardhman Special Steels' Liabilities

We can see from the most recent balance sheet that Vardhman Special Steels had liabilities of ₹2.31b falling due within a year, and liabilities of ₹1.13b due beyond that. Offsetting these obligations, it had cash of ₹629.5m as well as receivables valued at ₹2.19b due within 12 months. So it has liabilities totalling ₹610.2m more than its cash and near-term receivables, combined.

Since publicly traded Vardhman Special Steels shares are worth a total of ₹10.9b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.98 and interest cover of 5.2 times, it seems to us that Vardhman Special Steels is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Vardhman Special Steels's EBIT launched higher than Elon Musk, gaining a whopping 292% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Vardhman Special Steels 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, 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, Vardhman Special Steels produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Vardhman Special Steels's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Vardhman Special Steels's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For instance, we've identified 3 warning signs for Vardhman Special Steels (1 shouldn'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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