Is Environmental Group (ASX:EGL) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that The Environmental Group Limited (ASX:EGL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Environmental Group

What Is Environmental Group's Net Debt?

The image below, which you can click on for greater detail, shows that Environmental Group had debt of AU$3.54m at the end of December 2020, a reduction from AU$3.79m over a year. On the flip side, it has AU$1.26m in cash leading to net debt of about AU$2.28m.

A Look At Environmental Group's Liabilities

According to the last reported balance sheet, Environmental Group had liabilities of AU$11.5m due within 12 months, and liabilities of AU$4.15m due beyond 12 months. Offsetting these obligations, it had cash of AU$1.26m as well as receivables valued at AU$8.15m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.20m.

While this might seem like a lot, it is not so bad since Environmental Group has a market capitalization of AU$17.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Environmental Group will need earnings to service that debt. 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.

In the last year Environmental Group wasn't profitable at an EBIT level, but managed to grow its revenue by 6.6%, to AU$43m. That rate of growth is a bit slow for our taste, but it takes all types to make a world.

Caveat Emptor

Importantly, Environmental Group had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost AU$680k at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of AU$880k into a profit. In the meantime, we consider the stock very risky. 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 example, we've discovered 4 warning signs for Environmental Group (1 shouldn't be ignored!) that you should be aware of before investing here.

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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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