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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Automated Systems Holdings Limited (HKG:771) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Automated Systems Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Automated Systems Holdings had HK$544.0m of debt, an increase on HK$487.4m, over one year. On the flip side, it has HK$510.2m in cash leading to net debt of about HK$33.8m.
How Healthy Is Automated Systems Holdings's Balance Sheet?
The latest balance sheet data shows that Automated Systems Holdings had liabilities of HK$1.10b due within a year, and liabilities of HK$79.4m falling due after that. Offsetting these obligations, it had cash of HK$510.2m as well as receivables valued at HK$523.0m due within 12 months. So its liabilities total HK$149.9m more than the combination of its cash and short-term receivables.
Automated Systems Holdings has a market capitalization of HK$716.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
With net debt sitting at just 0.17 times EBITDA, Automated Systems Holdings is arguably pretty conservatively geared. And it boasts interest cover of 7.4 times, which is more than adequate. And we also note warmly that Automated Systems Holdings grew its EBIT by 11% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Automated Systems Holdings 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Automated Systems Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Automated Systems Holdings's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Looking at the bigger picture, we think Automated Systems Holdings's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Automated Systems Holdings's earnings per share history for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.