Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Magontec Limited (ASX:MGL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Magontec's Debt?
You can click the graphic below for the historical numbers, but it shows that Magontec had AU$12.6m of debt in June 2021, down from AU$14.5m, one year before. However, because it has a cash reserve of AU$2.36m, its net debt is less, at about AU$10.2m.
How Strong Is Magontec's Balance Sheet?
We can see from the most recent balance sheet that Magontec had liabilities of AU$24.1m falling due within a year, and liabilities of AU$17.6m due beyond that. Offsetting these obligations, it had cash of AU$2.36m as well as receivables valued at AU$24.4m due within 12 months. So it has liabilities totalling AU$15.0m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Magontec is worth AU$29.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Magontec has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.0 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Notably, Magontec made a loss at the EBIT level, last year, but improved that to positive EBIT of AU$1.9m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Magontec will need earnings to service that debt. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Magontec generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for Magontec was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Considering this range of data points, we think Magontec is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 4 warning signs for Magontec you should be aware of, and 1 of them doesn't sit too well with us.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
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Magontec Limited, together with its subsidiaries, engages in the research, development, manufacture, and sale of generic and specialist alloys in Asia, the Americas, Europe, and internationally.
Flawless balance sheet with outstanding track record.