Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Combined Motor Holdings Limited (JSE:CMH) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Combined Motor Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that Combined Motor Holdings had debt of R540.9m at the end of February 2021, a reduction from R695.1m over a year. However, it does have R754.8m in cash offsetting this, leading to net cash of R214.0m.
A Look At Combined Motor Holdings' Liabilities
According to the last reported balance sheet, Combined Motor Holdings had liabilities of R1.82b due within 12 months, and liabilities of R547.9m due beyond 12 months. Offsetting this, it had R754.8m in cash and R240.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R1.37b.
This deficit is considerable relative to its market capitalization of R1.50b, 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. Despite its noteworthy liabilities, Combined Motor Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The bad news is that Combined Motor Holdings saw its EBIT decline by 16% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Happily for any shareholders, Combined Motor Holdings actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While Combined Motor Holdings does have more liabilities than liquid assets, it also has net cash of R214.0m. The cherry on top was that in converted 118% of that EBIT to free cash flow, bringing in R353m. So while Combined Motor Holdings does not have a great balance sheet, it's certainly not too bad. 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 Combined Motor Holdings (at least 2 which can't be ignored) , 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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