Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, G. K. Goh Holdings Limited (SGX:G41) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is G. K. Goh Holdings's Debt?
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, it does have S$60.3m in cash offsetting this, leading to net debt of about S$136.6m.
A Look At G. K. Goh Holdings's Liabilities
We can see from the most recent balance sheet that G. K. Goh Holdings had liabilities of S$113.3m falling due within a year, and liabilities of S$148.0m due beyond that. On the other hand, it had cash of S$60.3m and S$43.5m worth of receivables due within a year. So its liabilities total S$157.5m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of S$240.4m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
G. K. Goh Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (12.3), and fairly weak interest coverage, since EBIT is just 0.23 times the interest expense. 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 it can keep walking that path it will be in a position to shed its debt with relative ease. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, G. K. Goh Holdings burned a lot of cash. 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 everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we've identified 3 warning signs for G. K. Goh Holdings (2 are significant) 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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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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