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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies McMillan Shakespeare Limited (ASX:MMS) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 McMillan Shakespeare's Net Debt?
The image below, which you can click on for greater detail, shows that McMillan Shakespeare had debt of AU$180.7m at the end of December 2020, a reduction from AU$331.8m over a year. However, it does have AU$117.1m in cash offsetting this, leading to net debt of about AU$63.7m.
How Healthy Is McMillan Shakespeare's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that McMillan Shakespeare had liabilities of AU$176.3m due within 12 months and liabilities of AU$202.2m due beyond that. Offsetting this, it had AU$117.1m in cash and AU$40.6m in receivables that were due within 12 months. So it has liabilities totalling AU$220.8m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since McMillan Shakespeare has a market capitalization of AU$842.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
McMillan Shakespeare's net debt is only 0.39 times its EBITDA. And its EBIT covers its interest expense a whopping 12.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, McMillan Shakespeare saw its EBIT drop by 7.6% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine McMillan Shakespeare'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. Happily for any shareholders, McMillan Shakespeare actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
The good news is that McMillan Shakespeare's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. When we consider the range of factors above, it looks like McMillan Shakespeare is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example McMillan Shakespeare has 4 warning signs (and 1 which is significant) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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