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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that MotorCycle Holdings Limited (ASX:MTO) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is MotorCycle Holdings's Net Debt?
The chart below, which you can click on for greater detail, shows that MotorCycle Holdings had AU$75.2m in debt in June 2020; about the same as the year before. On the flip side, it has AU$39.5m in cash leading to net debt of about AU$35.7m.
How Healthy Is MotorCycle Holdings's Balance Sheet?
The latest balance sheet data shows that MotorCycle Holdings had liabilities of AU$65.3m due within a year, and liabilities of AU$70.2m falling due after that. On the other hand, it had cash of AU$39.5m and AU$7.59m worth of receivables due within a year. So its liabilities total AU$88.5m 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$147.5m, 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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
MotorCycle Holdings's net debt of 1.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.2 times interest expense) certainly does not do anything to dispel this impression. In addition to that, we're happy to report that MotorCycle Holdings has boosted its EBIT by 33%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MotorCycle Holdings can strengthen its balance sheet over time. 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. Happily for any shareholders, MotorCycle Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
MotorCycle Holdings's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like MotorCycle Holdings is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for MotorCycle Holdings (of which 1 is potentially serious!) you should know about.
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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