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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 note that Wagners Holding Company Limited (ASX:WGN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 Wagners Holding’s Net Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Wagners Holding had debt of AU$94.3m, up from AU$73.4m in one year. However, because it has a cash reserve of AU$11.6m, its net debt is less, at about AU$82.7m.
How Healthy Is Wagners Holding’s Balance Sheet?
The latest balance sheet data shows that Wagners Holding had liabilities of AU$54.0m due within a year, and liabilities of AU$75.0m falling due after that. Offsetting these obligations, it had cash of AU$11.6m as well as receivables valued at AU$30.0m due within 12 months. So it has liabilities totalling AU$87.5m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Wagners Holding has a market capitalization of AU$322.8m, 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. Since Wagners Holding does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Wagners Holding has net debt worth 1.93 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 5.04 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Wagners Holding’s EBIT fell a jaw-dropping 27% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Wagners Holding’s ability to maintain a healthy balance sheet going forward. 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 it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Wagners Holding’s free cash flow amounted to 35% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We’d go so far as to say Wagners Holding’s EBIT growth rate was disappointing. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Wagners Holding’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Wagners Holding’s earnings per share history for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.