David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Welldone Company (GTSM:6170) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Welldone Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Welldone had NT$832.1m of debt, an increase on NT$748.2m, over one year. However, it does have NT$643.3m in cash offsetting this, leading to net debt of about NT$188.8m.
How Healthy Is Welldone's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Welldone had liabilities of NT$1.42b due within 12 months and liabilities of NT$55.5m due beyond that. On the other hand, it had cash of NT$643.3m and NT$809.8m worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Welldone's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the NT$1.78b company is short on cash, but still worth keeping an eye on the balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Welldone has a low net debt to EBITDA ratio of only 0.93. And its EBIT easily covers its interest expense, being 13.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Welldone grew its EBIT by 166% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Welldone 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Welldone saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Welldone's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Welldone can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Welldone has 4 warning signs (and 1 which shouldn't be ignored) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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