Here's Why Eureka Group Holdings (ASX:EGH) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Eureka Group Holdings Limited (ASX:EGH) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Eureka Group Holdings

What Is Eureka Group Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Eureka Group Holdings had debt of AU$54.8m, up from AU$49.5m in one year. However, it does have AU$2.45m in cash offsetting this, leading to net debt of about AU$52.3m.

How Strong Is Eureka Group Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Eureka Group Holdings had liabilities of AU$3.40m due within 12 months and liabilities of AU$55.9m due beyond that. Offsetting these obligations, it had cash of AU$2.45m as well as receivables valued at AU$712.0k due within 12 months. So its liabilities total AU$56.2m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Eureka Group Holdings is worth AU$103.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

With a net debt to EBITDA ratio of 5.7, it's fair to say Eureka Group Holdings does have a significant amount of debt. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. The good news is that Eureka Group Holdings grew its EBIT a smooth 31% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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 Eureka Group Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Eureka Group Holdings recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Both Eureka Group Holdings's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its net debt to EBITDA had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Eureka Group Holdings is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Eureka Group Holdings (1 is concerning!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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. 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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