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. As with many other companies People Infrastructure Ltd (ASX:PPE) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 step when considering a company's debt levels is to consider its cash and debt together.
What Is People Infrastructure's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 People Infrastructure had debt of AU$39.9m, up from AU$12.5m in one year. However, because it has a cash reserve of AU$21.3m, its net debt is less, at about AU$18.5m.
A Look At People Infrastructure's Liabilities
Zooming in on the latest balance sheet data, we can see that People Infrastructure had liabilities of AU$41.1m due within 12 months and liabilities of AU$36.6m due beyond that. Offsetting these obligations, it had cash of AU$21.3m as well as receivables valued at AU$37.9m due within 12 months. So it has liabilities totalling AU$18.5m more than its cash and near-term receivables, combined.
Since publicly traded People Infrastructure shares are worth a total of AU$229.5m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
People Infrastructure has net debt of just 0.98 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.7 times the interest expense over the last year. In addition to that, we're happy to report that People Infrastructure has boosted its EBIT by 70%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if People Infrastructure can strengthen its balance sheet over time. 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 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. During the last three years, People Infrastructure produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, People Infrastructure's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, People Infrastructure seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We'd be very excited to see if People Infrastructure insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.