Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that AMS Public Transport Holdings Limited (HKG:77) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is AMS Public Transport Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that AMS Public Transport Holdings had HK$149.7m of debt in March 2019, down from HK$159.4m, one year before. However, because it has a cash reserve of HK$33.9m, its net debt is less, at about HK$115.8m.
How Healthy Is AMS Public Transport Holdings's Balance Sheet?
We can see from the most recent balance sheet that AMS Public Transport Holdings had liabilities of HK$64.5m falling due within a year, and liabilities of HK$122.1m due beyond that. Offsetting this, it had HK$33.9m in cash and HK$8.33m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$144.4m.
This deficit is considerable relative to its market capitalization of HK$239.3m, so it does suggest shareholders should keep an eye on AMS Public Transport Holdings's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
AMS Public Transport Holdings's net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 10.6 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. It is well worth noting that AMS Public Transport Holdings's EBIT shot up like bamboo after rain, gaining 60% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is AMS Public Transport 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.
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. In the last three years, AMS Public Transport Holdings's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
AMS Public Transport Holdings's EBIT growth rate was a real positive on this analysis, as was its interest cover. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that AMS Public Transport Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that AMS Public Transport Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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