Wescoal Holdings (JSE:WSL) Has A Somewhat Strained Balance Sheet

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.' 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 can see that Wescoal Holdings Limited (JSE:WSL) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Wescoal Holdings

How Much Debt Does Wescoal Holdings Carry?

As you can see below, Wescoal Holdings had R999.7m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had R244.7m in cash, and so its net debt is R754.9m.

How Healthy Is Wescoal Holdings' Balance Sheet?

According to the last reported balance sheet, Wescoal Holdings had liabilities of R1.77b due within 12 months, and liabilities of R1.42b due beyond 12 months. Offsetting this, it had R244.7m in cash and R664.8m in receivables that were due within 12 months. So its liabilities total R2.28b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the R457.8m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Wescoal Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

While Wescoal Holdings has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 0.62. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. Notably, Wescoal Holdings made a loss at the EBIT level, last year, but improved that to positive EBIT of R48m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Wescoal Holdings's earnings that will influence how the balance sheet holds up in the future. 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Wescoal Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Wescoal Holdings's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Wescoal Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 4 warning signs with Wescoal Holdings (at least 2 which are significant) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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