Is Merchant House International (ASX:MHI) Using Too Much Debt?

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.' 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. We can see that Merchant House International Limited (ASX:MHI) does use debt in its business. But the more important question is: how much risk is that debt creating?

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 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.

View our latest analysis for Merchant House International

What Is Merchant House International's Net Debt?

As you can see below, Merchant House International had AU$12.5m of debt at September 2020, down from AU$15.5m a year prior. However, it also had AU$1.97m in cash, and so its net debt is AU$10.6m.

How Strong Is Merchant House International's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Merchant House International had liabilities of AU$25.6m due within 12 months and liabilities of AU$87.0k due beyond that. Offsetting this, it had AU$1.97m in cash and AU$11.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$11.8m.

The deficiency here weighs heavily on the AU$4.62m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Merchant House International would likely require a major re-capitalisation if it had to pay its creditors today. There's no doubt that we learn most about debt from the balance sheet. But it is Merchant House International's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Merchant House International made a loss at the EBIT level, and saw its revenue drop to AU$44m, which is a fall of 36%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Merchant House International's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost a very considerable AU$8.3m at the EBIT level. If you consider the significant liabilities mentioned above, we are extremely wary of this investment. That said, it is possible that the company will turn its fortunes around. But we think that is unlikely since it is low on liquid assets, and made a loss of AU$17m in the last year. So while it's not wise to assume the company will fail, we do think it's risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Merchant House International is showing 2 warning signs in our investment analysis , you should know about...

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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