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Is MotorCycle Holdings (ASX:MTO) Using Too Much Debt?

Simply Wall St

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that MotorCycle Holdings Limited (ASX:MTO) does use debt in its business. But is this debt a concern to shareholders?

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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for MotorCycle Holdings

What Is MotorCycle Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2018 MotorCycle Holdings had debt of AU$78.8m, up from AU$71.8m in one year. On the flip side, it has AU$5.05m in cash leading to net debt of about AU$73.7m.

ASX:MTO Historical Debt, August 3rd 2019

A Look At MotorCycle Holdings's Liabilities

We can see from the most recent balance sheet that MotorCycle Holdings had liabilities of AU$47.7m falling due within a year, and liabilities of AU$55.4m due beyond that. Offsetting these obligations, it had cash of AU$5.05m as well as receivables valued at AU$9.61m due within 12 months. So its liabilities total AU$88.4m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of AU$89.5m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

With net debt to EBITDA of 3.3 MotorCycle Holdings has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.8 times its interest expense, and its net debt to EBITDA, was quite high, at 3.3. Importantly, MotorCycle Holdings grew its EBIT by 34% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine MotorCycle Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, MotorCycle Holdings recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis MotorCycle Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about MotorCycle Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that MotorCycle Holdings 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.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.