Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Willas-Array Electronics (Holdings) Limited (SGX:BDR) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Willas-Array Electronics (Holdings) Carry?
As you can see below, Willas-Array Electronics (Holdings) had HK$1.03b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has HK$302.0m in cash leading to net debt of about HK$724.1m.
How Healthy Is Willas-Array Electronics (Holdings)’s Balance Sheet?
According to the last reported balance sheet, Willas-Array Electronics (Holdings) had liabilities of HK$1.38b due within 12 months, and liabilities of HK$28.7m due beyond 12 months. On the other hand, it had cash of HK$302.0m and HK$780.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$329.8m.
When you consider that this deficiency exceeds the company’s HK$285.0m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Willas-Array Electronics (Holdings) shareholders face the double whammy of a high net debt to EBITDA ratio (10.5), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Worse, Willas-Array Electronics (Holdings)’s EBIT was down 56% 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 you can’t view debt in total isolation; since Willas-Array Electronics (Holdings) will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Willas-Array Electronics (Holdings) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Willas-Array Electronics (Holdings)’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We think the chances that Willas-Array Electronics (Holdings) has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Even though Willas-Array Electronics (Holdings) lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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.
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