Is PEC (SGX:IX2) Using Too Much Debt?

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.' 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, PEC Ltd. (SGX:IX2) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for PEC

What Is PEC's Debt?

The chart below, which you can click on for greater detail, shows that PEC had S$19.2m in debt in December 2020; about the same as the year before. However, its balance sheet shows it holds S$139.2m in cash, so it actually has S$119.9m net cash.

How Strong Is PEC's Balance Sheet?

We can see from the most recent balance sheet that PEC had liabilities of S$172.8m falling due within a year, and liabilities of S$26.1m due beyond that. On the other hand, it had cash of S$139.2m and S$136.2m worth of receivables due within a year. So it can boast S$76.4m more liquid assets than total liabilities.

This surplus strongly suggests that PEC has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, PEC boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact PEC's saving grace is its low debt levels, because its EBIT has tanked 34% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is PEC'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, a company can only pay off debt with cold hard cash, not accounting profits. PEC may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, PEC generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to investigate a company's debt, in this case PEC has S$119.9m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of S$54m, being 99% of its EBIT. So we don't think PEC's use of debt is 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. We've identified 2 warning signs with PEC (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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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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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