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. We can see that ePlus inc. (NASDAQ:PLUS) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does ePlus Carry?
The image below, which you can click on for greater detail, shows that at June 2019 ePlus had debt of US$209.0m, up from US$184.2m in one year. On the flip side, it has US$35.6m in cash leading to net debt of about US$173.4m.
How Strong Is ePlus's Balance Sheet?
We can see from the most recent balance sheet that ePlus had liabilities of US$407.4m falling due within a year, and liabilities of US$38.8m due beyond that. On the other hand, it had cash of US$35.6m and US$408.1m worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to ePlus's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$1.08b company is struggling for cash, we still think it's worth monitoring its balance sheet.
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.
We'd say that ePlus's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. Sadly, ePlus's EBIT actually dropped 2.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 ePlus'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. Over the last three years, ePlus reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On our analysis ePlus's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that ePlus is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that ePlus insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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