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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Broadway Industrial Group Limited (SGX:B69) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Broadway Industrial Group's Debt?
As you can see below, Broadway Industrial Group had S$21.6m of debt at June 2020, down from S$30.4m a year prior. On the flip side, it has S$16.0m in cash leading to net debt of about S$5.59m.
A Look At Broadway Industrial Group's Liabilities
The latest balance sheet data shows that Broadway Industrial Group had liabilities of S$110.8m due within a year, and liabilities of S$9.26m falling due after that. On the other hand, it had cash of S$16.0m and S$50.3m worth of receivables due within a year. So it has liabilities totalling S$53.8m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of S$56.2m, so it does suggest shareholders should keep an eye on Broadway Industrial Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).
Broadway Industrial Group has a very low debt to EBITDA ratio of 0.36 so it is strange to see weak interest coverage, with last year's EBIT being only 1.8 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Broadway Industrial Group improved its EBIT from a last year's loss to a positive S$1.7m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Broadway Industrial Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Broadway Industrial Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We feel some trepidation about Broadway Industrial Group's difficulty interest cover, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. We think that Broadway Industrial Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Broadway Industrial Group that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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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