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 APAC Realty Limited (SGX:CLN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 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, 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 APAC Realty's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 APAC Realty had debt of S$56.1m, up from in one year. However, it does have S$24.8m in cash offsetting this, leading to net debt of about S$31.2m.
How Healthy Is APAC Realty's Balance Sheet?
The latest balance sheet data shows that APAC Realty had liabilities of S$77.7m due within a year, and liabilities of S$61.6m falling due after that. On the other hand, it had cash of S$24.8m and S$72.8m worth of receivables due within a year. So its liabilities total S$41.7m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since APAC Realty has a market capitalization of S$179.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
APAC Realty has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 23.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for APAC Realty if management cannot prevent a repeat of the 38% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine APAC Realty's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, APAC Realty generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Based on what we've seen APAC Realty is not finding it easy EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think APAC Realty is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that APAC Realty insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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