Is Ovostar Union (WSE:OVO) A Risky Investment?

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.' 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. We note that Ovostar Union Public Company Limited (WSE:OVO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Ovostar Union

What Is Ovostar Union's Debt?

You can click the graphic below for the historical numbers, but it shows that Ovostar Union had US$9.54m of debt in September 2020, down from US$12.0m, one year before. However, because it has a cash reserve of US$1.13m, its net debt is less, at about US$8.41m.

How Healthy Is Ovostar Union's Balance Sheet?

The latest balance sheet data shows that Ovostar Union had liabilities of US$17.9m due within a year, and liabilities of US$3.81m falling due after that. On the other hand, it had cash of US$1.13m and US$13.1m worth of receivables due within a year. So it has liabilities totalling US$7.43m more than its cash and near-term receivables, combined.

Given Ovostar Union has a market capitalization of US$129.7m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Ovostar Union's net debt is only 0.85 times its EBITDA. And its EBIT covers its interest expense a whopping 47.0 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Ovostar Union saw its EBIT decline by 6.8% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ovostar Union's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ovostar Union recorded negative free cash flow, in total. 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.

Our View

When it comes to the balance sheet, the standout positive for Ovostar Union was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. Looking at all this data makes us feel a little cautious about Ovostar Union's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Ovostar Union is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

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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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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