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. Importantly, EFT Solutions Holdings Limited (HKG:8062) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does EFT Solutions Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 EFT Solutions Holdings had HK$207.2m of debt, an increase on HK$5.00m, over one year. On the flip side, it has HK$38.2m in cash leading to net debt of about HK$169.0m.
How Healthy Is EFT Solutions Holdings's Balance Sheet?
We can see from the most recent balance sheet that EFT Solutions Holdings had liabilities of HK$97.3m falling due within a year, and liabilities of HK$138.0m due beyond that. Offsetting this, it had HK$38.2m in cash and HK$55.2m in receivables that were due within 12 months. So it has liabilities totalling HK$141.9m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$91.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, EFT Solutions Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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).
EFT Solutions Holdings has a rather high debt to EBITDA ratio of 5.1 which suggests a meaningful debt load. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that EFT Solutions Holdings saw its EBIT drop by 18% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is EFT Solutions Holdings's earnings that will influence how the balance sheet holds up in the future. 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, EFT Solutions Holdings reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, EFT Solutions Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. Taking into account all the aforementioned factors, it looks like EFT Solutions Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 EFT Solutions Holdings's earnings per share history for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.