Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 New Silkroutes Group Limited (SGX:BMT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 New Silkroutes Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 New Silkroutes Group had US$26.0m of debt, an increase on US$23.3m, over one year. However, it does have US$16.6m in cash offsetting this, leading to net debt of about US$9.39m.
How Healthy Is New Silkroutes Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that New Silkroutes Group had liabilities of US$62.4m due within 12 months and liabilities of US$5.23m due beyond that. Offsetting this, it had US$16.6m in cash and US$38.6m in receivables that were due within 12 months. So its liabilities total US$12.5m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because New Silkroutes Group is worth US$37.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While New Silkroutes Group's debt to EBITDA ratio (2.7) suggests that it uses some debt, its interest cover is very weak, at 0.92, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that New Silkroutes Group actually grew its EBIT by a hefty 242%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But it is New Silkroutes Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, New Silkroutes Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither New Silkroutes Group's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that New Silkroutes Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given our hesitation about the stock, it would be good to know if New Silkroutes Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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