Chelyabinsk Forge-and-Press Plant (MCX:CHKZ) Use Of Debt Could Be Considered Risky

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. Importantly, Chelyabinsk Forge-and-Press Plant, Public Joint Stock Company (MCX:CHKZ) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Chelyabinsk Forge-and-Press Plant

How Much Debt Does Chelyabinsk Forge-and-Press Plant Carry?

As you can see below, at the end of September 2020, Chelyabinsk Forge-and-Press Plant had ₽5.08b of debt, up from ₽4.09b a year ago. Click the image for more detail. However, it does have ₽282.2m in cash offsetting this, leading to net debt of about ₽4.80b.

A Look At Chelyabinsk Forge-and-Press Plant's Liabilities

According to the last reported balance sheet, Chelyabinsk Forge-and-Press Plant had liabilities of ₽6.98b due within 12 months, and liabilities of ₽2.74b due beyond 12 months. On the other hand, it had cash of ₽282.2m and ₽1.75b worth of receivables due within a year. So its liabilities total ₽7.68b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₽3.59b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Chelyabinsk Forge-and-Press Plant 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). 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).

Chelyabinsk Forge-and-Press Plant has a debt to EBITDA ratio of 4.3 and its EBIT covered its interest expense 2.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Chelyabinsk Forge-and-Press Plant improved its EBIT by 6.2% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chelyabinsk Forge-and-Press Plant'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Chelyabinsk Forge-and-Press Plant reported free cash flow worth 15% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Chelyabinsk Forge-and-Press Plant's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Chelyabinsk Forge-and-Press Plant's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Chelyabinsk Forge-and-Press Plant has 3 warning signs (and 1 which is potentially serious) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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