Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies KSG Agro S.A. (WSE:KSG) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is KSG Agro's Net Debt?
As you can see below, KSG Agro had US$27.5m of debt at March 2021, down from US$32.6m a year prior. Net debt is about the same, since the it doesn't have much cash.
How Strong Is KSG Agro's Balance Sheet?
According to the last reported balance sheet, KSG Agro had liabilities of US$25.1m due within 12 months, and liabilities of US$32.5m due beyond 12 months. Offsetting these obligations, it had cash of US$154.0k as well as receivables valued at US$3.03m due within 12 months. So its liabilities total US$54.5m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$16.3m 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 definitely think shareholders need to watch this one closely. At the end of the day, KSG Agro would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
KSG Agro shareholders face the double whammy of a high net debt to EBITDA ratio (10.5), and fairly weak interest coverage, since EBIT is just 0.74 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that KSG Agro achieved a positive EBIT of US$1.4m 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 you can't view debt in total isolation; since KSG Agro 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, KSG Agro recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On the face of it, KSG Agro'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. Having said that, its ability to grow its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like KSG Agro has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For instance, we've identified 4 warning signs for KSG Agro (1 shouldn't be ignored) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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