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. We can see that Equiniti Group plc (LON:EQN) does use debt in its business. But should shareholders be worried about its use of debt?
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 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Equiniti Group’s Debt?
You can click the graphic below for the historical numbers, but it shows that Equiniti Group had UK£361.1m of debt in June 2020, down from UK£383.2m, one year before. However, it does have UK£48.0m in cash offsetting this, leading to net debt of about UK£313.1m.
How Strong Is Equiniti Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Equiniti Group had liabilities of UK£150.9m due within 12 months and liabilities of UK£432.9m due beyond that. Offsetting this, it had UK£48.0m in cash and UK£128.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£407.8m.
When you consider that this deficiency exceeds the company’s UK£400.4m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Equiniti Group’s debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Even worse, Equiniti Group saw its EBIT tank 44% over the last 12 months. 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 it is future earnings, more than anything, that will determine Equiniti Group’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, Equiniti Group produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Mulling over Equiniti Group’s attempt at (not) growing its EBIT, we’re certainly not enthusiastic. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, we think it’s fair to say that Equiniti Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 2 warning signs for Equiniti Group that you should be aware of.
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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