Is Ovostar Union (WSE:OVO) Using Too Much Debt?

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.' 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, Ovostar Union Public Company Limited (WSE:OVO) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Ovostar Union

What Is Ovostar Union's Net Debt?

The chart below, which you can click on for greater detail, shows that Ovostar Union had US$10.8m in debt in December 2020; about the same as the year before. However, it also had US$1.63m in cash, and so its net debt is US$9.14m.

A Look At Ovostar Union's Liabilities

We can see from the most recent balance sheet that Ovostar Union had liabilities of US$21.4m falling due within a year, and liabilities of US$5.48m due beyond that. On the other hand, it had cash of US$1.63m and US$15.9m worth of receivables due within a year. So its liabilities total US$9.42m more than the combination of its cash and short-term receivables.

Of course, Ovostar Union has a market capitalization of US$131.7m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Ovostar Union has a low net debt to EBITDA ratio of only 0.95. And its EBIT easily covers its interest expense, being 14.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Ovostar Union grew its EBIT by 14% last year, making its debt load easier to handle. 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 Ovostar Union 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ovostar Union burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Ovostar Union's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Ovostar Union is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Ovostar Union is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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