Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that G. K. Goh Holdings Limited (SGX:G41) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does G. K. Goh Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2020 G. K. Goh Holdings had debt of S$196.9m, up from S$178.5m in one year. However, because it has a cash reserve of S$60.3m, its net debt is less, at about S$136.6m.
How Strong Is G. K. Goh Holdings's Balance Sheet?
According to the last reported balance sheet, G. K. Goh Holdings had liabilities of S$113.3m due within 12 months, and liabilities of S$148.0m due beyond 12 months. On the other hand, it had cash of S$60.3m and S$43.5m worth of receivables due within a year. So it has liabilities totalling S$157.5m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of S$243.6m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Weak interest cover of 0.23 times and a disturbingly high net debt to EBITDA ratio of 12.3 hit our confidence in G. K. Goh Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The silver lining is that G. K. Goh Holdings grew its EBIT by 243% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since G. K. Goh Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, G. K. Goh Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both G. K. Goh Holdings's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that G. K. Goh Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 G. K. Goh Holdings is showing 3 warning signs in our investment analysis , and 2 of those are significant...
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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