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. 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. As with many other companies Universal Electronics Inc. (NASDAQ:UEIC) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Universal Electronics's Net Debt?
The image below, which you can click on for greater detail, shows that Universal Electronics had debt of US$95.0m at the end of June 2019, a reduction from US$111.0m over a year. However, because it has a cash reserve of US$49.6m, its net debt is less, at about US$45.4m.
How Healthy Is Universal Electronics's Balance Sheet?
According to the last reported balance sheet, Universal Electronics had liabilities of US$290.4m due within 12 months, and liabilities of US$27.0m due beyond 12 months. On the other hand, it had cash of US$49.6m and US$181.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$86.4m.
Since publicly traded Universal Electronics shares are worth a total of US$657.3m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Given net debt is only 1.1 times EBITDA, it is initially surprising to see that Universal Electronics's EBIT has low interest coverage of 2.0 times. So one way or the other, it's clear the debt levels are not trivial. We also note that Universal Electronics improved its EBIT from a last year's loss to a positive US$9.2m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Universal Electronics 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Universal Electronics actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Universal Electronics'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 the stark truth is that we are concerned by its interest cover. All these things considered, it appears that Universal Electronics can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Universal Electronics 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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