Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Combined Motor Holdings Limited (JSE:CMH) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
What Is Combined Motor Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Combined Motor Holdings had R578.6m of debt in August 2020, down from R628.8m, one year before. However, its balance sheet shows it holds R609.6m in cash, so it actually has R31.0m net cash.
How Healthy Is Combined Motor Holdings' Balance Sheet?
According to the last reported balance sheet, Combined Motor Holdings had liabilities of R1.84b due within 12 months, and liabilities of R611.4m due beyond 12 months. Offsetting these obligations, it had cash of R609.6m as well as receivables valued at R302.4m due within 12 months. So its liabilities total R1.54b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's R1.11b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Combined Motor Holdings boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
Shareholders should be aware that Combined Motor Holdings's EBIT was down 39% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Combined Motor Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Combined Motor Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While Combined Motor Holdings does have more liabilities than liquid assets, it also has net cash of R31.0m. And it impressed us with free cash flow of R431m, being 111% of its EBIT. Despite the cash, we do find Combined Motor Holdings's EBIT growth rate concerning, so we're not particularly comfortable with the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Combined Motor Holdings (at least 2 which are concerning) , and understanding them should be part of your investment process.
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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