Warren Buffett famously said, ‘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. As with many other companies Action Construction Equipment Limited (NSE:ACE) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
How Much Debt Does Action Construction Equipment Carry?
As you can see below, Action Construction Equipment had ₹532.4m of debt at March 2019, down from ₹783.0m a year prior. However, because it has a cash reserve of ₹380.3m, its net debt is less, at about ₹152.2m.
How Healthy Is Action Construction Equipment’s Balance Sheet?
According to the last reported balance sheet, Action Construction Equipment had liabilities of ₹3.94b due within 12 months, and liabilities of ₹554.5m due beyond 12 months. Offsetting this, it had ₹380.3m in cash and ₹1.47b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.64b.
Action Construction Equipment has a market capitalization of ₹9.73b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). 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).
With net debt sitting at just 0.15 times EBITDA, Action Construction Equipment is arguably pretty conservatively geared. And it boasts interest cover of 9.8 times, which is more than adequate. The good news is that Action Construction Equipment has increased its EBIT by 7.9% over twelve months, which should ease any concerns about debt repayment. 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 Action Construction Equipment’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Action Construction Equipment recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Action Construction Equipment’s demonstrated ability handle its debt, based on its EBITDA, delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its interest cover is also very heartening. When we consider the range of factors above, it looks like Action Construction Equipment is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Action Construction Equipment insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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