Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 EVA Precision Industrial Holdings Limited (HKG:838) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is EVA Precision Industrial Holdings’s Debt?
You can click the graphic below for the historical numbers, but it shows that EVA Precision Industrial Holdings had HK$1.98b of debt in June 2019, down from HK$2.30b, one year before. However, it also had HK$1.37b in cash, and so its net debt is HK$615.1m.
A Look At EVA Precision Industrial Holdings’s Liabilities
Zooming in on the latest balance sheet data, we can see that EVA Precision Industrial Holdings had liabilities of HK$2.41b due within 12 months and liabilities of HK$845.3m due beyond that. Offsetting this, it had HK$1.37b in cash and HK$919.5m in receivables that were due within 12 months. So its liabilities total HK$973.1m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of HK$1.11b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
EVA Precision Industrial Holdings’s net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 3.2 times last year. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Unfortunately, EVA Precision Industrial Holdings saw its EBIT slide 6.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There’s no doubt that we learn most about debt from the balance sheet. But it is EVA Precision Industrial 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, EVA Precision Industrial Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over EVA Precision Industrial Holdings’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. Having said that, its ability handle its debt, based on its EBITDA, isn’t such a worry. Overall, it seems to us that EVA Precision Industrial Holdings’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our hesitation about the stock, it would be good to know if EVA Precision Industrial Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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