Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, AMS Public Transport Holdings Limited (HKG:77) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does AMS Public Transport Holdings Carry?
As you can see below, AMS Public Transport Holdings had HK$153.7m of debt, at September 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of HK$30.0m, its net debt is less, at about HK$123.7m.
A Look At AMS Public Transport Holdings’s Liabilities
The latest balance sheet data shows that AMS Public Transport Holdings had liabilities of HK$135.0m due within a year, and liabilities of HK$127.6m falling due after that. Offsetting this, it had HK$30.0m in cash and HK$6.60m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$226.0m.
This is a mountain of leverage relative to its market capitalization of HK$231.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
AMS Public Transport Holdings has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 8.6 suggests it can easily service that debt. It is well worth noting that AMS Public Transport Holdings’s EBIT shot up like bamboo after rain, gaining 39% in the last twelve months. That’ll make it easier to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is AMS Public Transport 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. During the last three years, AMS Public Transport Holdings generated free cash flow amounting to a very robust 82% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
The good news is that AMS Public Transport Holdings’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that AMS Public Transport Holdings can handle its debt fairly comfortably. 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. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Be aware that AMS Public Transport Holdings is showing 4 warning signs in our investment analysis , and 1 of those shouldn’t be ignored…
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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