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 Epwin Group PLC (LON:EPWN) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Epwin Group's Net Debt?
As you can see below, at the end of June 2019, Epwin Group had UK£37.7m of debt, up from UK£34.4m a year ago. Click the image for more detail. However, it also had UK£10.3m in cash, and so its net debt is UK£27.4m.
How Strong Is Epwin Group's Balance Sheet?
According to the last reported balance sheet, Epwin Group had liabilities of UK£74.1m due within 12 months, and liabilities of UK£91.9m due beyond 12 months. Offsetting this, it had UK£10.3m in cash and UK£48.8m in receivables that were due within 12 months. So its liabilities total UK£106.9m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of UK£118.6m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). 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).
Epwin Group's net debt is only 0.93 times its EBITDA. And its EBIT covers its interest expense a whopping 10.7 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Epwin Group has been able to increase its EBIT by 27% in twelve months, making it easier to pay down 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 Epwin Group'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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Epwin Group generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Epwin Group's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Epwin Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Epwin Group's dividend history, without delay!
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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