We Think Eureka Group Holdings (ASX:EGH) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Eureka Group Holdings Limited (ASX:EGH) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Eureka Group Holdings

What Is Eureka Group Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Eureka Group Holdings had debt of AU$64.5m, up from AU$45.6m in one year. However, it does have AU$1.99m in cash offsetting this, leading to net debt of about AU$62.5m.

A Look At Eureka Group Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Eureka Group Holdings had liabilities of AU$4.49m due within 12 months and liabilities of AU$66.9m due beyond that. Offsetting these obligations, it had cash of AU$1.99m as well as receivables valued at AU$1.05m due within 12 months. So its liabilities total AU$68.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Eureka Group Holdings is worth AU$142.6m, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 7.3, it's fair to say Eureka Group Holdings does have a significant amount of debt. However, its interest coverage of 3.2 is reasonably strong, which is a good sign. Even more troubling is the fact that Eureka Group Holdings actually let its EBIT decrease by 3.3% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Eureka Group Holdings generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Eureka Group Holdings's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Eureka Group Holdings's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Eureka Group Holdings (including 1 which shouldn't be ignored) .

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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