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. We can see that Gemilang International Limited (HKG:6163) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Gemilang International Carry?
You can click the graphic below for the historical numbers, but it shows that Gemilang International had US$7.95m of debt in April 2019, down from US$10.7m, one year before. However, because it has a cash reserve of US$2.42m, its net debt is less, at about US$5.53m.
How Healthy Is Gemilang International's Balance Sheet?
According to the last reported balance sheet, Gemilang International had liabilities of US$25.0m due within 12 months, and liabilities of US$90.0k due beyond 12 months. Offsetting these obligations, it had cash of US$2.42m as well as receivables valued at US$9.61m due within 12 months. So its liabilities total US$13.1m more than the combination of its cash and short-term receivables.
Gemilang International has a market capitalization of US$44.3m, 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). 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).
While Gemilang International's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.1 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Gemilang International improved its EBIT from a last year's loss to a positive US$4.2m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Gemilang International will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Gemilang International generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Gemilang International's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its net debt to EBITDA was a positive. Looking at all the aforementioned factors together, it strikes us that Gemilang International can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Gemilang International insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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