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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. As with many other companies. Energy Action Limited (ASX:EAX) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Energy Action’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Energy Action had AU$5.54m of debt in December 2018, down from AU$7.76m, one year before However, it does have AU$1.03m in cash offsetting this, leading to net debt of about AU$4.51m.
A Look At Energy Action’s Liabilities
We can see from the most recent balance sheet that Energy Action had liabilities of AU$8.68m falling due within a year, and liabilities of AU$1.97m due beyond that. On the other hand, it had cash of AU$1.03m and AU$3.87m worth of receivables due within a year. So it has liabilities totalling AU$5.74m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Energy Action has a market capitalization of AU$10.9m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Because it carries more debt than cash, we think it’s worth watching Energy Action’s balance sheet over time.
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.
Even though Energy Action’s debt is only 2.12, its interest cover is really very low at 2.23. In large part that’s it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it’s safe to say the company has meaningful debt. Importantly, Energy Action’s EBIT fell a jaw-dropping 86% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Energy Action’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Energy Action created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks some a little paranoia about is ability to extinguish debt.
Mulling over Energy Action’s attempt at (not) growing its EBIT, we’re certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Overall, it seems to us that Energy Action’s debt load is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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.
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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.