These 4 Measures Indicate That Electrocomponents (LON:ECM) Is Using Debt Reasonably Well

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.' 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. Importantly, Electrocomponents plc (LON:ECM) does carry debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Electrocomponents

What Is Electrocomponents's Debt?

As you can see below, at the end of September 2020, Electrocomponents had UK£300.9m of debt, up from UK£257.7m a year ago. Click the image for more detail. However, it also had UK£242.6m in cash, and so its net debt is UK£58.3m.

A Look At Electrocomponents's Liabilities

The latest balance sheet data shows that Electrocomponents had liabilities of UK£572.7m due within a year, and liabilities of UK£331.0m falling due after that. Offsetting this, it had UK£242.6m in cash and UK£397.1m in receivables that were due within 12 months. So it has liabilities totalling UK£264.0m more than its cash and near-term receivables, combined.

Since publicly traded Electrocomponents shares are worth a total of UK£3.58b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Electrocomponents's net debt is only 0.31 times its EBITDA. And its EBIT easily covers its interest expense, being 25.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Electrocomponents has seen its EBIT plunge 11% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Electrocomponents's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Electrocomponents produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Electrocomponents's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Electrocomponents can handle its debt fairly comfortably. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Electrocomponents , and understanding them should be part of your investment process.

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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