David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. We note that Qube Holdings Limited (ASX:QUB) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Qube Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Qube Holdings had AU$1.50b of debt, an increase on AU$967.1m, over one year. However, it also had AU$139.9m in cash, and so its net debt is AU$1.36b.
How Healthy Is Qube Holdings’s Balance Sheet?
According to the last reported balance sheet, Qube Holdings had liabilities of AU$346.5m due within 12 months, and liabilities of AU$1.59b due beyond 12 months. On the other hand, it had cash of AU$139.9m and AU$326.8m worth of receivables due within a year. So it has liabilities totalling AU$1.47b more than its cash and near-term receivables, combined.
Qube Holdings has a market capitalization of AU$5.29b, so it could very likely raise cash to ameliorate 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.
Qube Holdings has a debt to EBITDA ratio of 4.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.1 is very high, suggesting that the interest expense may well rise in the future, even if there hasn’t yet been a major cost attached to that debt. One way Qube Holdings could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 11%, as it did over the last year. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Qube 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Qube Holdings reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
When it comes to the balance sheet, the standout positive for Qube Holdings was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren’t so heartening. To be specific, it seems about as good at managing its debt, based on its EBITDA, as wet socks are at keeping your feet warm. It’s also worth noting that Qube Holdings is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Qube Holdings’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We’d be motivated to research the stock further if we found out that Qube Holdings insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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