Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Agile Group Holdings Limited (HKG:3383) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Agile Group Holdings's Net Debt?
As you can see below, at the end of December 2018, Agile Group Holdings had CN¥94.1b of debt, up from CN¥65.1b a year ago. Click the image for more detail. However, it does have CN¥39.0b in cash offsetting this, leading to net debt of about CN¥55.1b.
A Look At Agile Group Holdings's Liabilities
According to the last reported balance sheet, Agile Group Holdings had liabilities of CN¥120.4b due within 12 months, and liabilities of CN¥55.1b due beyond 12 months. Offsetting these obligations, it had cash of CN¥39.0b as well as receivables valued at CN¥25.7b due within 12 months. So its liabilities total CN¥110.8b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥33.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Agile Group Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Agile Group Holdings has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 37.1 is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. One way Agile Group Holdings could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 19%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Agile Group Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Agile Group Holdings's free cash flow amounted to 22% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say Agile Group Holdings's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Agile Group Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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