These 4 Measures Indicate That Pepkor Holdings (JSE:PPH) Is Using Debt Extensively

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.' 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. As with many other companies Pepkor Holdings Limited (JSE:PPH) 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Pepkor Holdings

How Much Debt Does Pepkor Holdings Carry?

The image below, which you can click on for greater detail, shows that Pepkor Holdings had debt of R12.8b at the end of September 2020, a reduction from R17.3b over a year. However, because it has a cash reserve of R5.24b, its net debt is less, at about R7.52b.

How Healthy Is Pepkor Holdings' Balance Sheet?

The latest balance sheet data shows that Pepkor Holdings had liabilities of R18.9b due within a year, and liabilities of R29.7b falling due after that. Offsetting these obligations, it had cash of R5.24b as well as receivables valued at R7.04b due within 12 months. So its liabilities total R36.3b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R56.7b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 0.99 times EBITDA, it is initially surprising to see that Pepkor Holdings's EBIT has low interest coverage of 2.3 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly Pepkor Holdings's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Pepkor Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Pepkor Holdings recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Pepkor Holdings's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. Taking the abovementioned factors together we do think Pepkor Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Pepkor Holdings you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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