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.' 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 can see that Millennium Services Group Limited (ASX:MIL) does use debt in its business. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Millennium Services Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Millennium Services Group had AU$8.20m of debt in December 2021, down from AU$8.73m, one year before. However, because it has a cash reserve of AU$1.38m, its net debt is less, at about AU$6.82m.
A Look At Millennium Services Group's Liabilities
The latest balance sheet data shows that Millennium Services Group had liabilities of AU$50.5m due within a year, and liabilities of AU$3.74m falling due after that. Offsetting this, it had AU$1.38m in cash and AU$24.4m in receivables that were due within 12 months. So it has liabilities totalling AU$28.5m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of AU$21.1m, we think shareholders really should watch Millennium Services Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Millennium Services Group's low debt to EBITDA ratio of 0.92 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Millennium Services Group made a loss at the EBIT level, last year, but improved that to positive EBIT of AU$3.3m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Millennium Services Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Millennium Services Group actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Neither Millennium Services Group's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Millennium Services Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Millennium Services Group (of which 1 is a bit concerning!) you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.