Here's Why AusGroup (SGX:5GJ) Can Afford Some 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.' 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 can see that AusGroup Limited (SGX:5GJ) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for AusGroup

What Is AusGroup's Net Debt?

The image below, which you can click on for greater detail, shows that AusGroup had debt of AU$71.5m at the end of September 2020, a reduction from AU$79.0m over a year. However, it also had AU$20.9m in cash, and so its net debt is AU$50.6m.

How Strong Is AusGroup's Balance Sheet?

The latest balance sheet data shows that AusGroup had liabilities of AU$38.7m due within a year, and liabilities of AU$81.0m falling due after that. Offsetting this, it had AU$20.9m in cash and AU$44.1m in receivables that were due within 12 months. So it has liabilities totalling AU$54.7m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$71.4m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. 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 AusGroup 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.

In the last year AusGroup had a loss before interest and tax, and actually shrunk its revenue by 13%, to AU$236m. We would much prefer see growth.

Caveat Emptor

While AusGroup's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable AU$10m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. For example, we would not want to see a repeat of last year's loss of AU$63m. So in short it's a really risky stock. 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. Take risks, for example - AusGroup has 2 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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