These 4 Measures Indicate That EVA Precision Industrial Holdings (HKG:838) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that EVA Precision Industrial Holdings Limited (HKG:838) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for EVA Precision Industrial Holdings

How Much Debt Does EVA Precision Industrial Holdings Carry?

As you can see below, EVA Precision Industrial Holdings had HK$1.90b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$1.44b in cash offsetting this, leading to net debt of about HK$462.8m.

How Healthy Is EVA Precision Industrial Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that EVA Precision Industrial Holdings had liabilities of HK$2.77b due within 12 months and liabilities of HK$717.9m due beyond that. Offsetting this, it had HK$1.44b in cash and HK$1.15b in receivables that were due within 12 months. So its liabilities total HK$905.4m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$1.48b, so it does suggest shareholders should keep an eye on EVA Precision Industrial Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

EVA Precision Industrial Holdings's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 2.6 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Shareholders should be aware that EVA Precision Industrial Holdings's EBIT was down 41% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is EVA Precision Industrial Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, EVA Precision Industrial Holdings reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over EVA Precision Industrial Holdings's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Overall, it seems to us that EVA Precision Industrial Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 EVA Precision Industrial Holdings you should know about.

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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