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. 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. As with many other companies Anglo-Eastern Plantations Plc (LON:AEP) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Anglo-Eastern Plantations's Debt?
As you can see below, Anglo-Eastern Plantations had US$16.1m of debt at June 2019, down from US$25.6m a year prior. However, its balance sheet shows it holds US$100.1m in cash, so it actually has US$84.1m net cash.
How Healthy Is Anglo-Eastern Plantations's Balance Sheet?
We can see from the most recent balance sheet that Anglo-Eastern Plantations had liabilities of US$36.9m falling due within a year, and liabilities of US$30.9m due beyond that. On the other hand, it had cash of US$100.1m and US$44.7m worth of receivables due within a year. So it actually has US$77.0m more liquid assets than total liabilities.
This luscious liquidity implies that Anglo-Eastern Plantations's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Simply put, the fact that Anglo-Eastern Plantations has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Anglo-Eastern Plantations's load is not too heavy, because its EBIT was down 76% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Anglo-Eastern Plantations'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Anglo-Eastern Plantations may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Anglo-Eastern Plantations created free cash flow amounting to 17% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While it is always sensible to investigate a company's debt, in this case Anglo-Eastern Plantations has US$84.1m in net cash and a decent-looking balance sheet. So we are not troubled with Anglo-Eastern Plantations's debt use. While Anglo-Eastern Plantations didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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