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 MotorCycle Holdings Limited (ASX:MTO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
How Much Debt Does MotorCycle Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that MotorCycle Holdings had AU$18.9m of debt in December 2020, down from AU$77.2m, one year before. On the flip side, it has AU$7.43m in cash leading to net debt of about AU$11.5m.
How Strong Is MotorCycle Holdings' Balance Sheet?
The latest balance sheet data shows that MotorCycle Holdings had liabilities of AU$62.4m due within a year, and liabilities of AU$35.4m falling due after that. On the other hand, it had cash of AU$7.43m and AU$8.79m worth of receivables due within a year. So its liabilities total AU$81.6m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since MotorCycle Holdings has a market capitalization of AU$150.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
MotorCycle Holdings's net debt is only 0.28 times its EBITDA. And its EBIT covers its interest expense a whopping 19.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, MotorCycle Holdings grew its EBIT by 143% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MotorCycle Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, MotorCycle Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
MotorCycle Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Zooming out, MotorCycle Holdings seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Case in point: We've spotted 4 warning signs for MotorCycle Holdings you should be aware of, and 1 of them is concerning.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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