Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Midway Limited (ASX:MWY) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Midway's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Midway had AU$34.5m of debt in June 2019, down from AU$42.7m, one year before. On the flip side, it has AU$15.5m in cash leading to net debt of about AU$19.0m.
A Look At Midway's Liabilities
We can see from the most recent balance sheet that Midway had liabilities of AU$38.8m falling due within a year, and liabilities of AU$95.5m due beyond that. On the other hand, it had cash of AU$15.5m and AU$24.7m worth of receivables due within a year. So it has liabilities totalling AU$94.2m more than its cash and near-term receivables, combined.
Midway has a market capitalization of AU$234.1m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Midway has a low net debt to EBITDA ratio of only 0.63. And its EBIT easily covers its interest expense, being 18.7 times the size. So we're pretty relaxed about its super-conservative use of debt. The good news is that Midway has increased its EBIT by 6.3% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Midway 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 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, Midway's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On our analysis Midway's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Midway'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 Midway 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.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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