Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Exel Composites Oyj (HEL:EXL1V) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Exel Composites Oyj's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Exel Composites Oyj had debt of €39.7m, up from €37.2m in one year. On the flip side, it has €12.0m in cash leading to net debt of about €27.7m.
A Look At Exel Composites Oyj's Liabilities
The latest balance sheet data shows that Exel Composites Oyj had liabilities of €54.1m due within a year, and liabilities of €13.8m falling due after that. Offsetting these obligations, it had cash of €12.0m as well as receivables valued at €20.9m due within 12 months. So its liabilities total €35.1m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Exel Composites Oyj has a market capitalization of €116.1m, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Exel Composites Oyj's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 16.0 times, makes us even more comfortable. Importantly, Exel Composites Oyj grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. 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 Exel Composites Oyj'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, Exel Composites Oyj reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
The good news is that Exel Composites Oyj's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Exel Composites Oyj can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Exel Composites Oyj you should know about.
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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