Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 PEC Ltd. (SGX:IX2) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is PEC's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 PEC had S$18.6m of debt, an increase on S$8.61m, over one year. But it also has S$80.6m in cash to offset that, meaning it has S$62.0m net cash.
How Healthy Is PEC's Balance Sheet?
According to the last reported balance sheet, PEC had liabilities of S$119.4m due within 12 months, and liabilities of S$8.51m due beyond 12 months. Offsetting this, it had S$80.6m in cash and S$181.8m in receivables that were due within 12 months. So it actually has S$134.5m more liquid assets than total liabilities.
This surplus strongly suggests that PEC has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that PEC has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, PEC saw its EBIT drop by 5.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is PEC's earnings that will influence how the balance sheet holds up in the future. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. PEC may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, PEC saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
While it is always sensible to investigate a company's debt, in this case PEC has S$62m in net cash and a decent-looking balance sheet. So we are not troubled with PEC's debt use. We'd be motivated to research the stock further if we found out that PEC 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.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.