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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Embelton Limited (ASX:EMB) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
How Much Debt Does Embelton Carry?
As you can see below, at the end of December 2018, Embelton had AU$7.00m of debt, up from AU$6.60m a year ago. Click the image for more detail. On the flip side, it has AU$1.09m in cash leading to net debt of about AU$5.92m.
How Healthy Is Embelton’s Balance Sheet?
The latest balance sheet data shows that Embelton had liabilities of AU$6.34m due within a year, and liabilities of AU$7.20m falling due after that. Offsetting this, it had AU$1.09m in cash and AU$7.55m in receivables that were due within 12 months. So its liabilities total AU$4.90m more than the combination of its cash and short-term receivables.
Embelton has a market capitalization of AU$22.7m, so it could very likely ameliorate its balance sheet if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Since Embelton does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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.
Embelton’s net debt is only 1.40 times its EBITDA. And its EBIT covers its interest expense a whopping 11.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Embelton grew its EBIT by 2.8% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Embelton 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Embelton 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.
Embelton’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 interest cover was refreshing. Looking at all the angles mentioned above, it does seem to us that Embelton is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.