Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that QAF Limited (SGX:Q01) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does QAF Carry?
The image below, which you can click on for greater detail, shows that at June 2019 QAF had debt of S$110.0m, up from S$101.7m in one year. However, because it has a cash reserve of S$58.0m, its net debt is less, at about S$51.9m.
A Look At QAF's Liabilities
According to the last reported balance sheet, QAF had liabilities of S$203.1m due within 12 months, and liabilities of S$111.9m due beyond 12 months. Offsetting this, it had S$58.0m in cash and S$120.7m in receivables that were due within 12 months. So it has liabilities totalling S$136.2m more than its cash and near-term receivables, combined.
This deficit isn't so bad because QAF is worth S$425.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Given net debt is only 1.1 times EBITDA, it is initially surprising to see that QAF's EBIT has low interest coverage of 1.9 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, QAF's EBIT fell a jaw-dropping 24% in the last twelve months. 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 you can't view debt in total isolation; since QAF will need earnings to service that debt. 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. So we always check how much of that EBIT is translated into free cash flow. During the last three years, QAF burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both QAF's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. We're quite clear that we consider QAF to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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