Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Shaver Shop Group Limited (ASX:SSG) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Shaver Shop Group Carry?
As you can see below, Shaver Shop Group had AU$10.3m of debt at June 2019, down from AU$11.3m a year prior. On the flip side, it has AU$3.94m in cash leading to net debt of about AU$6.38m.
How Strong Is Shaver Shop Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Shaver Shop Group had liabilities of AU$19.2m due within 12 months and liabilities of AU$13.3m due beyond that. Offsetting this, it had AU$3.94m in cash and AU$3.11m in receivables that were due within 12 months. So it has liabilities totalling AU$25.5m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Shaver Shop Group has a market capitalization of AU$84.1m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Shaver Shop Group has a low net debt to EBITDA ratio of only 0.51. And its EBIT easily covers its interest expense, being 17.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Shaver Shop Group’s EBIT was pretty flat over the last year, but that shouldn’t be an issue given the it doesn’t have a lot of debt. 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 Shaver Shop Group’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. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shaver Shop Group produced sturdy free cash flow equating to 62% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Shaver Shop Group’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. All these things considered, it appears that Shaver Shop Group can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. We’d be motivated to research the stock further if we found out that Shaver Shop Group insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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