Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that WPG Holdings Limited (TPE:3702) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is WPG Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 WPG Holdings had NT$86.0b of debt, an increase on NT$75.7b, over one year. On the flip side, it has NT$13.2b in cash leading to net debt of about NT$72.8b.
How Strong Is WPG Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that WPG Holdings had liabilities of NT$142.9b due within 12 months and liabilities of NT$27.4b due beyond that. Offsetting this, it had NT$13.2b in cash and NT$126.5b in receivables that were due within 12 months. So its liabilities total NT$30.7b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since WPG Holdings has a market capitalization of NT$76.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
With a net debt to EBITDA ratio of 7.1, it's fair to say WPG Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.7 times, suggesting it can responsibly service its obligations. WPG Holdings grew its EBIT by 3.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine WPG Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, WPG Holdings recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
WPG Holdings's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. Taking the abovementioned factors together we do think WPG Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 1 warning sign for WPG Holdings 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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