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. 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 Willas-Array Electronics (Holdings) Limited (SGX:BDR) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Willas-Array Electronics (Holdings) Carry?
You can click the graphic below for the historical numbers, but it shows that Willas-Array Electronics (Holdings) had HK$994.7m of debt in June 2019, down from HK$1.05b, one year before. On the flip side, it has HK$294.9m in cash leading to net debt of about HK$699.9m.
How Healthy Is Willas-Array Electronics (Holdings)'s Balance Sheet?
The latest balance sheet data shows that Willas-Array Electronics (Holdings) had liabilities of HK$1.40b due within a year, and liabilities of HK$36.4m falling due after that. On the other hand, it had cash of HK$294.9m and HK$836.5m worth of receivables due within a year. So its liabilities total HK$307.8m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of HK$270.5m, we think shareholders really should watch Willas-Array Electronics (Holdings)'s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
Weak interest cover of 0.22 times and a disturbingly high net debt to EBITDA ratio of 29.5 hit our confidence in Willas-Array Electronics (Holdings) like a one-two punch to the gut. The debt burden here is substantial. Even worse, Willas-Array Electronics (Holdings) saw its EBIT tank 93% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Willas-Array Electronics (Holdings)'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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Willas-Array Electronics (Holdings) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Willas-Array Electronics (Holdings)'s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering all the factors previously mentioned, we think that Willas-Array Electronics (Holdings) really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. While Willas-Array Electronics (Holdings) didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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