Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Eagle Nice (International) Holdings Limited (HKG:2368) does carry debt. But the real question is whether this debt is making the company risky.
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Eagle Nice (International) Holdings Carry?
As you can see below, at the end of March 2019, Eagle Nice (International) Holdings had HK$572.2m of debt, up from HK$196.8m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$249.1m, its net debt is less, at about HK$323.1m.
How Healthy Is Eagle Nice (International) Holdings's Balance Sheet?
We can see from the most recent balance sheet that Eagle Nice (International) Holdings had liabilities of HK$1.06b falling due within a year, and liabilities of HK$53.8m due beyond that. Offsetting these obligations, it had cash of HK$249.1m as well as receivables valued at HK$418.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$441.2m.
While this might seem like a lot, it is not so bad since Eagle Nice (International) Holdings has a market capitalization of HK$1.14b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
Eagle Nice (International) Holdings's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 20.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Eagle Nice (International) Holdings's EBIT dived 14%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Eagle Nice (International) Holdings 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 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, Eagle Nice (International) Holdings's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Eagle Nice (International) Holdings's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Eagle Nice (International) Holdings's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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