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. Importantly, Highlight Event and Entertainment AG (VTX:HLEE) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Highlight Event and Entertainment’s Debt?
As you can see below, at the end of December 2018, Highlight Event and Entertainment had CHF232.9m of debt, up from CHF163.9m a year ago. Click the image for more detail. On the flip side, it has CHF93.5m in cash leading to net debt of about CHF139.4m.
How Healthy Is Highlight Event and Entertainment’s Balance Sheet?
According to the last reported balance sheet, Highlight Event and Entertainment had liabilities of CHF456.0m due within 12 months, and liabilities of CHF117.7m due beyond 12 months. Offsetting these obligations, it had cash of CHF93.5m as well as receivables valued at CHF107.4m due within 12 months. So it has liabilities totalling CHF372.7m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CHF175.2m 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, Highlight Event and Entertainment would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Highlight Event and Entertainment shareholders face the double whammy of a high net debt to EBITDA ratio (12.4), and fairly weak interest coverage, since EBIT is just 0.35 times the interest expense. This means we’d consider it to have a heavy debt load. However, the silver lining was that Highlight Event and Entertainment achieved a positive EBIT of CHF3.3m in the last twelve months, an improvement on the prior year’s loss. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Highlight Event and Entertainment will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Highlight Event and Entertainment burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Highlight Event and Entertainment’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that Highlight Event and Entertainment really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. While Highlight Event and Entertainment didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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