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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies EML Payments Limited (ASX:EML) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is EML Payments's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2021 EML Payments had debt of AU$86.0m, up from AU$36.2m in one year. But it also has AU$86.2m in cash to offset that, meaning it has AU$195.0k net cash.
A Look At EML Payments' Liabilities
Zooming in on the latest balance sheet data, we can see that EML Payments had liabilities of AU$2.18b due within 12 months and liabilities of AU$148.2m due beyond that. Offsetting this, it had AU$86.2m in cash and AU$63.3m in receivables that were due within 12 months. So its liabilities total AU$2.17b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the AU$941.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, EML Payments would likely require a major re-capitalisation if it had to pay its creditors today. Given that EML Payments has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
The bad news is that EML Payments saw its EBIT decline by 19% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if EML Payments 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. While EML Payments has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, EML Payments's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Although EML Payments's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$195.0k. However, we do find both EML Payments's level of total liabilities and its interest cover troubling. So even though it has net cash, we do think the business has some risks worth watching. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - EML Payments has 3 warning signs we think you should be aware of.
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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.