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.’ 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. E-Commodities Holdings Limited (HKG:1733) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does E-Commodities Holdings Carry?
As you can see below, at the end of December 2018, E-Commodities Holdings had HK$2.77b of debt, up from HK$2.48b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$1.32b, its net debt is less, at about HK$1.46b.
How Strong Is E-Commodities Holdings’s Balance Sheet?
We can see from the most recent balance sheet that E-Commodities Holdings had liabilities of HK$4.44b falling due within a year, and liabilities of HK$230.2m due beyond that. Offsetting these obligations, it had cash of HK$1.32b as well as receivables valued at HK$3.69b due within 12 months. So it can boast HK$337.3m more liquid assets than total liabilities.
This excess liquidity suggests that E-Commodities Holdings is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don’t think it will have any issues with its lenders. Because it carries more debt than cash, we think it’s worth watching E-Commodities Holdings’s balance sheet 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). 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).
While E-Commodities Holdings’s low debt to EBITDA ratio of 1.35 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.41 last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. The bad news is that E-Commodities Holdings saw its EBIT decline by 10% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since E-Commodities Holdings will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, E-Commodities Holdings actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
E-Commodities Holdings’s struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its level of total liabilities was refreshing. Looking at all the angles mentioned above, it does seem to us that E-Commodities Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given E-Commodities 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.
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.
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