The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Tradehold Limited (JSE:TDH) does carry debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Tradehold
What Is Tradehold's Net Debt?
As you can see below, Tradehold had UK£390.9m of debt at August 2020, down from UK£463.0m a year prior. However, it also had UK£31.3m in cash, and so its net debt is UK£359.6m.
How Healthy Is Tradehold's Balance Sheet?
The latest balance sheet data shows that Tradehold had liabilities of UK£49.5m due within a year, and liabilities of UK£456.4m falling due after that. Offsetting this, it had UK£31.3m in cash and UK£19.1m in receivables that were due within 12 months. So it has liabilities totalling UK£455.5m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the UK£113.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Tradehold would probably need a major re-capitalization if its creditors were to demand repayment.
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).
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Tradehold like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Tradehold's EBIT was down 31% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tradehold 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Tradehold recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
On the face of it, Tradehold's EBIT growth rate 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. And even its interest cover fails to inspire much confidence. We think the chances that Tradehold has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Take risks, for example - Tradehold has 3 warning signs (and 2 which are a bit unpleasant) we think you should know about.
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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About JSE:CPP
Collins Property Group
An investment holding company, owns, develops, manages, and leases real estate properties.
Established dividend payer moderate.