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. 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. Importantly, AWF Madison Group Limited (NZSE:AWF) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is AWF Madison Group's Net Debt?
As you can see below, AWF Madison Group had NZ$33.0m of debt at March 2019, down from NZ$36.0m a year prior. On the flip side, it has NZ$6.36m in cash leading to net debt of about NZ$26.6m.
A Look At AWF Madison Group's Liabilities
According to the last reported balance sheet, AWF Madison Group had liabilities of NZ$25.2m due within 12 months, and liabilities of NZ$35.5m due beyond 12 months. Offsetting this, it had NZ$6.36m in cash and NZ$32.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$21.4m.
This deficit isn't so bad because AWF Madison Group is worth NZ$61.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
AWF Madison Group's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, AWF Madison Group's EBIT was down 49% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 AWF Madison Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, AWF Madison Group generated free cash flow amounting to a very robust 100% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Neither AWF Madison Group's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that AWF Madison Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check AWF Madison Group's dividend history, without delay!
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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