These 4 metrics indicate that Morgan Advanced Materials (LON:MGAM) is using debt reasonably well

Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Morgan Advanced Materials plc (LON:MGAM) uses debt in its business. But does this debt worry shareholders?

When is debt dangerous?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

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How much debt does Morgan Advanced Materials have?

As you can see below, at the end of June 2022, Morgan Advanced Materials had a debt of £197.9m, up from £172.8m a year ago. Click on the image for more details. However, he also had £121.6m in cash, so his net debt is £76.3m.

LSE: MGAM Debt to Equity September 29, 2022

A Look at Morgan Advanced Materials Liabilities

Zooming in on the latest balance sheet data, we can see that Morgan Advanced Materials had liabilities of £251.3m due within 12 months and liabilities of £323.6m due beyond. As compensation for these obligations, it had cash of £121.6 million as well as receivables valued at £195.8 million maturing within 12 months. It therefore has liabilities totaling £257.5 million more than its cash and short-term receivables, combined.

Morgan Advanced Materials has a market capitalization of £634.8m, so it could very likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Morgan Advanced Materials has a low net debt to EBITDA ratio of just 0.47. And its EBIT easily covers its interest costs, which is 17.0 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, we are happy to report that Morgan Advanced Materials increased its EBIT by 37%, reducing the specter of future debt repayments. There is no doubt that we learn the most about debt from the balance sheet. But future earnings, more than anything, will determine Morgan Advanced Materials’ ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Morgan Advanced Materials has had free cash flow of 62% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.

Our point of view

The good news is that Morgan Advanced Materials’ demonstrated ability to cover its interest charges with its EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its EBIT growth rate is also very encouraging. Overall, we think Morgan Advanced Materials’ use of debt seems entirely reasonable and we’re not worried about that. After all, reasonable leverage can increase return on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example, we found 1 warning sign for Morgan Advanced Materials which you should be aware of before investing here.

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.

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.

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