Is EML Payments (ASX:EML) A Risky Investment?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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?

When Is Debt Dangerous?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for EML Payments

What Is EML Payments's Debt?

As you can see below, at the end of June 2020, EML Payments had AU$35.8m of debt, up from AU$15.0m a year ago. Click the image for more detail. However, it does have AU$951.8m in cash offsetting this, leading to net cash of AU$915.9m.

How Healthy Is EML Payments's Balance Sheet?

We can see from the most recent balance sheet that EML Payments had liabilities of AU$1.33b falling due within a year, and liabilities of AU$139.0m due beyond that. Offsetting these obligations, it had cash of AU$951.8m as well as receivables valued at AU$44.0m due within 12 months. So it has liabilities totalling AU$469.5m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since EML Payments has a market capitalization of AU$1.43b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, EML Payments also has more cash than debt, so we're pretty confident it can manage its debt safely.

Importantly, EML Payments's EBIT fell a jaw-dropping 55% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Happily for any shareholders, EML Payments actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While EML Payments does have more liabilities than liquid assets, it also has net cash of AU$915.9m. The cherry on top was that in converted 136% of that EBIT to free cash flow, bringing in AU$11m. So while EML Payments does not have a great balance sheet, it's certainly not too bad. 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 be aware of the 2 warning signs we've spotted with EML Payments .

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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