Stock Analysis

These 4 Measures Indicate That MHM Automation (NZSE:MHM) Is Using Debt Reasonably Well

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NZSE:MHM
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that MHM Automation Limited (NZSE:MHM) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is MHM Automation's Net Debt?

As you can see below, MHM Automation had NZ$3.60m of debt at June 2020, down from NZ$6.37m a year prior. However, it does have NZ$2.32m in cash offsetting this, leading to net debt of about NZ$1.28m.

debt-equity-history-analysis
NZSE:MHM Debt to Equity History December 10th 2020

A Look At MHM Automation's Liabilities

According to the last reported balance sheet, MHM Automation had liabilities of NZ$15.1m due within 12 months, and liabilities of NZ$4.01m due beyond 12 months. On the other hand, it had cash of NZ$2.32m and NZ$4.96m worth of receivables due within a year. So its liabilities total NZ$11.8m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because MHM Automation is worth NZ$36.1m, and thus could probably raise enough capital to shore up 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.

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).

MHM Automation has a very low debt to EBITDA ratio of 1.4 so it is strange to see weak interest coverage, with last year's EBIT being only 1.6 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. It is well worth noting that MHM Automation's EBIT shot up like bamboo after rain, gaining 45% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since MHM Automation will need earnings to service that debt. 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, MHM Automation actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

MHM Automation's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its interest cover. When we consider the range of factors above, it looks like MHM Automation is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for MHM Automation (of which 1 shouldn't be ignored!) you should know about.

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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