David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Mahamaya Steel Industries Limited (NSE:MAHASTEEL) makes use of debt. But is this debt a concern to shareholders?
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. 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. 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.
What Is Mahamaya Steel Industries’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2023 Mahamaya Steel Industries had debt of ₹603.8m, up from ₹422.9m in one year. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Mahamaya Steel Industries’ Balance Sheet?
According to the last reported balance sheet, Mahamaya Steel Industries had liabilities of ₹769.2m due within 12 months, and liabilities of ₹309.0m due beyond 12 months. On the other hand, it had cash of ₹7.03m and ₹213.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹858.0m.
While this might seem like a lot, it is not so bad since Mahamaya Steel Industries has a market capitalization of ₹1.74b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Mahamaya Steel Industries’s debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 2.8 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. The good news is that Mahamaya Steel Industries improved its EBIT by 4.3% 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 you can’t view debt in total isolation; since Mahamaya Steel Industries 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Mahamaya Steel Industries burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over Mahamaya Steel Industries’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. But at least its EBIT growth rate is not so bad. Looking at the bigger picture, it seems clear to us that Mahamaya Steel Industries’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example Mahamaya Steel Industries has 4 warning signs (and 2 which are significant) we think you should know about.
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.
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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.