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. Importantly, Avance Gas Holding Ltd (OB:AVANCE) does carry debt. But the more important question is: how much risk is that debt creating?
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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Avance Gas Holding’s Debt?
As you can see below, Avance Gas Holding had US$521.1m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$67.0m in cash offsetting this, leading to net debt of about US$454.1m.
How Strong Is Avance Gas Holding’s Balance Sheet?
According to the last reported balance sheet, Avance Gas Holding had liabilities of US$52.6m due within 12 months, and liabilities of US$476.2m due beyond 12 months. Offsetting these obligations, it had cash of US$67.0m as well as receivables valued at US$27.7m due within 12 months. So its liabilities total US$434.1m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$231.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet.” So we’d watch its balance sheet closely, without a doubt After all, Avance Gas Holding would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.43 times and a disturbingly high net debt to EBITDA ratio of 8.7 hit our confidence in Avance Gas Holding like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Avance Gas Holding achieved a positive EBIT of US$13m in the last twelve months, an improvement on the prior year’s loss. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Avance Gas Holding 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, Avance Gas Holding created free cash flow amounting to 7.6% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Avance Gas Holding’s interest cover 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. After considering the datapoints discussed, we think Avance Gas Holding has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. Given the risks around Avance Gas Holding’s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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