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Here's Why Steppe Cement (LON:STCM) Can Manage Its Debt Responsibly

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.' 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. Importantly, Steppe Cement Ltd. (LON:STCM) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Steppe Cement

How Much Debt Does Steppe Cement Carry?

You can click the graphic below for the historical numbers, but it shows that Steppe Cement had US$3.21m of debt in June 2020, down from US$10.7m, one year before. However, its balance sheet shows it holds US$9.57m in cash, so it actually has US$6.36m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

How Healthy Is Steppe Cement's Balance Sheet?

The latest balance sheet data shows that Steppe Cement had liabilities of US$13.6m due within a year, and liabilities of US$11.7m falling due after that. Offsetting these obligations, it had cash of US$9.57m as well as receivables valued at US$6.62m due within 12 months. So it has liabilities totalling US$9.04m more than its cash and near-term receivables, combined.

Of course, Steppe Cement has a market capitalization of US$74.2m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Steppe Cement also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the other side of the story is that Steppe Cement saw its EBIT decline by 5.5% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Steppe Cement's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Steppe Cement has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Steppe Cement actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

Although Steppe Cement's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$6.36m. The cherry on top was that in converted 141% of that EBIT to free cash flow, bringing in US$20m. So we are not troubled with Steppe Cement's debt use. 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. Take risks, for example - Steppe Cement has 2 warning signs we think you should be aware of.

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.

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. 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.

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