The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 G. K. Goh Holdings Limited (SGX:G41) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is G. K. Goh Holdings's Net Debt?
As you can see below, G. K. Goh Holdings had S$213.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of S$90.0m, its net debt is less, at about S$123.0m.
How Healthy Is G. K. Goh Holdings' Balance Sheet?
According to the last reported balance sheet, G. K. Goh Holdings had liabilities of S$136.1m due within 12 months, and liabilities of S$140.5m due beyond 12 months. Offsetting this, it had S$90.0m in cash and S$23.1m in receivables that were due within 12 months. So its liabilities total S$163.5m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since G. K. Goh Holdings has a market capitalization of S$316.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
G. K. Goh Holdings has a debt to EBITDA ratio of 4.9 and its EBIT covered its interest expense 2.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that G. K. Goh Holdings actually grew its EBIT by a hefty 111%, over the last 12 months. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent two years, G. K. Goh Holdings recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Both G. K. Goh Holdings's ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its net debt to EBITDA had us nibbling our nails. Considering this range of data points, we think G. K. Goh Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 G. K. Goh Holdings is showing 4 warning signs in our investment analysis , and 2 of those can't be ignored...
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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