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. 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 note that AV Promotions Holdings Limited (HKG:8419) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is AV Promotions Holdings’s Debt?
The chart below shows that AV Promotions Holdings had debt of HK$66.6m at the end of the period to June 2019. However, it does have HK$14.9m in cash offsetting this, leading to net debt of about HK$51.7m.
How Strong Is AV Promotions Holdings’s Balance Sheet?
According to the last reported balance sheet, AV Promotions Holdings had liabilities of HK$81.8m due within 12 months, and liabilities of HK$67.3m due beyond 12 months. On the other hand, it had cash of HK$14.9m and HK$74.0m worth of receivables due within a year. So it has liabilities totalling HK$60.3m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because AV Promotions Holdings is worth HK$134.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
While AV Promotions Holdings’s low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.4 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. On the other hand, AV Promotions Holdings saw its EBIT drop by 3.6% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since AV Promotions 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.
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. Over the last three years, AV Promotions Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
AV Promotions Holdings’s struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its net debt to EBITDA is relatively strong. When we consider all the factors discussed, it seems to us that AV Promotions Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if AV Promotions Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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