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.' 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. As with many other companies Embry Holdings Limited (HKG:1388) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Embry Holdings Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Embry Holdings had debt of HK$427.1m, up from HK$326.1m in one year. However, because it has a cash reserve of HK$174.9m, its net debt is less, at about HK$252.1m.
How Strong Is Embry Holdings's Balance Sheet?
We can see from the most recent balance sheet that Embry Holdings had liabilities of HK$586.6m falling due within a year, and liabilities of HK$372.0m due beyond that. On the other hand, it had cash of HK$174.9m and HK$118.2m worth of receivables due within a year. So it has liabilities totalling HK$665.4m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of HK$768.8m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Embry Holdings's net debt is only 0.99 times its EBITDA. And its EBIT easily covers its interest expense, being 22.2 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Embry Holdings grew its EBIT at 17% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But it is Embry Holdings'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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Embry Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Neither Embry Holdings's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Embry 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. Given Embry Holdings has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.