David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Elecon Engineering Company Limited (NSE:ELECON) is in debt. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Elecon Engineering
What is Elecon Engineering’s net debt?
As you can see below, Elecon Engineering had a debt of ₹2.43 billion in September 2021, up from ₹4.05 billion the previous year. On the other hand, he has ₹1.47 billion in cash, resulting in a net debt of around ₹961.6 million.
A Look at Elecon Engineering’s Responsibilities
We can see from the most recent balance sheet that Elecon Engineering had liabilities of ₹7.44 billion due within a year, and liabilities of ₹1.36 billion due beyond. On the other hand, it had cash of ₹1.47 billion and ₹4.83 billion of receivables due within one year. It therefore has liabilities totaling ₹2.50 billion more than its cash and short-term receivables, combined.
Of course, Elecon Engineering has a market capitalization of ₹16.9 billion, so those liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.
While Elecon Engineering’s low debt to EBITDA ratio of 0.39 suggests only modest debt utilization, the fact that EBIT only covered interest expense by 5.9 times the last year makes us think. But the interest payments are certainly enough to make us think about the affordability of its debt. Fortunately, Elecon Engineering is growing its EBIT faster than former Australian Prime Minister Bob Hawke dropped a glass of yard, with a gain of 123% over the last twelve months. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; as Elecon Engineering will need revenue to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Fortunately for all shareholders, Elecon Engineering has actually produced more free cash flow than EBIT over the past three years. There’s nothing better than cash coming in to stay in your lenders’ good books.
Our point of view
Fortunately, Elecon Engineering’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. And the good news does not stop there, since its EBIT growth rate also confirms this impression! Considering this set of factors, we believe that Elecon Engineering is quite cautious with its leverage, and the risks appear to be well under control. The balance sheet therefore seems rather healthy to us. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. We have identified 1 warning sign with Elecon Engineering, and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.