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.’ 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 can see that Victoria plc (LON:VCP) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company’s debt levels is to consider its cash and debt together.
What Is Victoria’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Victoria had debt of UK£401.1m, up from UK£309.1m in one year. On the flip side, it has UK£66.4m in cash leading to net debt of about UK£334.7m.
How Healthy Is Victoria’s Balance Sheet?
The latest balance sheet data shows that Victoria had liabilities of UK£179.0m due within a year, and liabilities of UK£485.7m falling due after that. Offsetting this, it had UK£66.4m in cash and UK£111.3m in receivables that were due within 12 months. So it has liabilities totalling UK£487.0m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of UK£627.0m, so it does suggest shareholders should keep an eye on Victoria’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Victoria has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 2.9 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. On the other hand, Victoria grew its EBIT by 23% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Victoria’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Victoria’s free cash flow amounted to 36% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Neither Victoria’s ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Victoria’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Victoria insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.