The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies BOC Aviation Limited (HKG:2588) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is BOC Aviation's Debt?
As you can see below, BOC Aviation had US$16.8b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$487.6m in cash offsetting this, leading to net debt of about US$16.3b.
How Healthy Is BOC Aviation's Balance Sheet?
We can see from the most recent balance sheet that BOC Aviation had liabilities of US$2.21b falling due within a year, and liabilities of US$16.4b due beyond that. Offsetting this, it had US$487.6m in cash and US$172.2m in receivables that were due within 12 months. So its liabilities total US$18.0b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$5.27b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, BOC Aviation would probably need a major re-capitalization if its creditors were to demand repayment.
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).
BOC Aviation has a rather high debt to EBITDA ratio of 13.2 which suggests a meaningful debt load. However, its interest coverage of 2.5 is reasonably strong, which is a good sign. Fortunately, BOC Aviation grew its EBIT by 3.5% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if BOC Aviation can strengthen its balance sheet over time. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, BOC Aviation burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, BOC Aviation's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Taking into account all the aforementioned factors, it looks like BOC Aviation has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for BOC Aviation (1 makes us a bit uncomfortable) you should be aware of.
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.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.