Here's Why Combined Motor Holdings (JSE:CMH) Can Manage Its Debt Responsibly

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.' 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 Combined Motor Holdings Limited (JSE:CMH) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for Combined Motor Holdings

How Much Debt Does Combined Motor Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of February 2022 Combined Motor Holdings had R753.4m of debt, an increase on R545.9m, over one year. However, its balance sheet shows it holds R817.7m in cash, so it actually has R64.4m net cash.

How Strong Is Combined Motor Holdings' Balance Sheet?

We can see from the most recent balance sheet that Combined Motor Holdings had liabilities of R2.02b falling due within a year, and liabilities of R644.1m due beyond that. Offsetting these obligations, it had cash of R817.7m as well as receivables valued at R277.6m due within 12 months. So it has liabilities totalling R1.57b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of R2.12b, so it does suggest shareholders should keep an eye on Combined Motor Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Combined Motor Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Combined Motor Holdings has boosted its EBIT by 77%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Combined Motor Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Combined Motor Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Combined Motor Holdings recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While Combined Motor Holdings does have more liabilities than liquid assets, it also has net cash of R64.4m. And it impressed us with free cash flow of R362m, being 83% of its EBIT. So we don't have any problem with Combined Motor Holdings's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Combined Motor Holdings 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.