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. 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. As with many other companies Asaleo Care Limited (ASX:AHY) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Asaleo Care Carry?
The image below, which you can click on for greater detail, shows that Asaleo Care had debt of AU$181.0m at the end of June 2019, a reduction from AU$346.6m over a year. However, it does have AU$30.6m in cash offsetting this, leading to net debt of about AU$150.4m.
How Healthy Is Asaleo Care's Balance Sheet?
We can see from the most recent balance sheet that Asaleo Care had liabilities of AU$89.1m falling due within a year, and liabilities of AU$208.0m due beyond that. Offsetting this, it had AU$30.6m in cash and AU$15.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$250.6m.
While this might seem like a lot, it is not so bad since Asaleo Care has a market capitalization of AU$510.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Asaleo Care's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 3.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Asaleo Care's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Asaleo Care can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Asaleo Care recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
On the face of it, Asaleo Care's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Asaleo Care stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Asaleo Care's earnings per share history for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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