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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies KSH Holdings Limited (SGX:ER0) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is KSH Holdings’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that KSH Holdings had S$113.6m of debt in September 2019, down from S$141.7m, one year before. However, it also had S$30.6m in cash, and so its net debt is S$83.0m.
A Look At KSH Holdings’s Liabilities
According to the last reported balance sheet, KSH Holdings had liabilities of S$129.3m due within 12 months, and liabilities of S$100.0m due beyond 12 months. Offsetting this, it had S$30.6m in cash and S$67.8m in receivables that were due within 12 months. So its liabilities total S$130.9m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since KSH Holdings has a market capitalization of S$252.8m, 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
KSH Holdings’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 4.3 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. Worse, KSH Holdings’s EBIT was down 21% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is KSH Holdings’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. Looking at the most recent three years, KSH Holdings recorded free cash flow of 29% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Mulling over KSH Holdings’s attempt at (not) growing its EBIT, we’re certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn’t such a worry. Looking at the bigger picture, it seems clear to us that KSH Holdings’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given KSH Holdings has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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.
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.
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