David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Vicplas International Ltd (SGX:569) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Vicplas International's Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2019 Vicplas International had S$8.63m of debt, an increase on S$3.12m, over one year. On the flip side, it has S$4.11m in cash leading to net debt of about S$4.52m.
A Look At Vicplas International's Liabilities
We can see from the most recent balance sheet that Vicplas International had liabilities of S$20.2m falling due within a year, and liabilities of S$1.65m due beyond that. On the other hand, it had cash of S$4.11m and S$32.0m worth of receivables due within a year. So it can boast S$14.2m more liquid assets than total liabilities.
This surplus strongly suggests that Vicplas International has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, it seems its balance sheet is as strong as a black-belt karate master.
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).
Vicplas International's net debt is only 0.55 times its EBITDA. And its EBIT easily covers its interest expense, being 12.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Vicplas International grew its EBIT by 155% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is Vicplas International's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Vicplas International saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Happily, Vicplas International's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. We would also note that Medical Equipment industry companies like Vicplas International commonly do use debt without problems. Zooming out, Vicplas International seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Vicplas International'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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