Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Public Joint Stock Company “Ashinskiy metallurgical works” (MCX:AMEZ) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ashinskiy metallurgical works’s Debt?
You can click the graphic below for the historical numbers, but it shows that Ashinskiy metallurgical works had RUруб7.06b of debt in December 2018, down from RUруб7.39b, one year before. However, it also had RUруб558.5m in cash, and so its net debt is RUруб6.50b.
How Strong Is Ashinskiy metallurgical works’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ashinskiy metallurgical works had liabilities of RUруб4.11b due within 12 months and liabilities of RUруб5.83b due beyond that. Offsetting this, it had RUруб558.5m in cash and RUруб1.70b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RUруб7.68b.
The deficiency here weighs heavily on the RUруб2.10b 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 At the end of the day, Ashinskiy metallurgical works would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
Ashinskiy metallurgical works’s debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 5.7 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Notably Ashinskiy metallurgical works’s EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ashinskiy metallurgical works’s earnings that will influence how the balance sheet holds up in the future. 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 it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ashinskiy metallurgical works produced sturdy free cash flow equating to 52% 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.
We’d go so far as to say Ashinskiy metallurgical works’s level of total liabilities was disappointing. Having said that, its ability to convert EBIT to free cash flow isn’t such a worry. Overall, we think it’s fair to say that Ashinskiy metallurgical works has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Ashinskiy metallurgical works’s earnings per share history for free.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.