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. We can see that oOh!media Limited (ASX:OML) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is oOh!media's Debt?
As you can see below, at the end of December 2018, oOh!media had AU$407.5m of debt, up from AU$138.7m a year ago. Click the image for more detail. However, because it has a cash reserve of AU$33.0m, its net debt is less, at about AU$374.5m.
How Strong Is oOh!media's Balance Sheet?
We can see from the most recent balance sheet that oOh!media had liabilities of AU$120.7m falling due within a year, and liabilities of AU$445.8m due beyond that. Offsetting this, it had AU$33.0m in cash and AU$136.4m in receivables that were due within 12 months. So it has liabilities totalling AU$397.0m more than its cash and near-term receivables, combined.
oOh!media has a market capitalization of AU$701.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
oOh!media has net debt to EBITDA of 3.4 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.1 suggests it can easily service that debt. Also relevant is that oOh!media has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine oOh!media'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, oOh!media's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
oOh!media's EBIT growth rate was a real positive on this analysis, as was its interest cover. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about oOh!media's debt levels. 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 oOh!media 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.
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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.