Here's Why Macmahon Holdings (ASX:MAH) Can Manage Its Debt Responsibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Macmahon Holdings Limited (ASX:MAH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Macmahon Holdings

What Is Macmahon Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Macmahon Holdings had AU$217.9m of debt, an increase on AU$158.5m, over one year. On the flip side, it has AU$196.0m in cash leading to net debt of about AU$21.9m.

How Healthy Is Macmahon Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Macmahon Holdings had liabilities of AU$462.1m due within 12 months and liabilities of AU$336.3m due beyond that. On the other hand, it had cash of AU$196.0m and AU$328.4m worth of receivables due within a year. So its liabilities total AU$274.0m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$325.8m, so it does suggest shareholders should keep an eye on Macmahon Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Macmahon Holdings's net debt to EBITDA ratio is very low, at 0.098, suggesting the debt is only trivial. But EBIT was only 4.7 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. If Macmahon Holdings can keep growing EBIT at last year's rate of 20% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Macmahon Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Macmahon Holdings recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Macmahon Holdings's demonstrated ability handle its debt, based on its EBITDA, delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Macmahon Holdings can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example - Macmahon Holdings has 1 warning sign we think you should be aware of.

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.