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.' 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 note that AP Oil International Limited (SGX:5AU) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is AP Oil International's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 AP Oil International had S$6.20m of debt, an increase on S$4.45m, over one year. However, it does have S$34.3m in cash offsetting this, leading to net cash of S$28.1m.
How Healthy Is AP Oil International's Balance Sheet?
We can see from the most recent balance sheet that AP Oil International had liabilities of S$9.57m falling due within a year, and liabilities of S$8.49m due beyond that. On the other hand, it had cash of S$34.3m and S$7.81m worth of receivables due within a year. So it actually has S$24.1m more liquid assets than total liabilities.
This luscious liquidity implies that AP Oil International's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, AP Oil International boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that AP Oil International has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since AP Oil International 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. AP Oil International 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, AP Oil International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While we empathize with investors who find debt concerning, the bottom line is that AP Oil International has net cash of S$28.1m and plenty of liquid assets. So we are not troubled with AP Oil International's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that AP Oil International is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...
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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