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.’ 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. We note that Marshall Motor Holdings Plc (LON:MMH) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Marshall Motor Holdings’s Debt?
As you can see below, Marshall Motor Holdings had UK£6.31m of debt at December 2018, down from UK£7.11m a year prior. On the flip side, it has UK£1.17m in cash leading to net debt of about UK£5.13m.
How Strong Is Marshall Motor Holdings’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Marshall Motor Holdings had liabilities of UK£503.8m due within 12 months and liabilities of UK£32.0m due beyond that. Offsetting these obligations, it had cash of UK£1.17m as well as receivables valued at UK£71.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£462.7m.
This deficit casts a shadow over the UK£108.7m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt At the end of the day, Marshall Motor Holdings would probably need a major re-capitalization if its creditors were to demand repayment. Either way, since Marshall Motor Holdings does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Marshall Motor Holdings’s low debt to EBITDA ratio of 0.12 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.03 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Marshall Motor Holdings saw its EBIT slide 2.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Marshall Motor Holdings’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Marshall Motor Holdings created free cash flow amounting to 20% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks some a little paranoia about is ability to extinguish debt.
Mulling over Marshall Motor Holdings’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. We’re quite clear that we consider Marshall Motor Holdings to be really rather risky, as a result of its debt. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Given Marshall Motor Holdings has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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