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 can see that Universal Technologies Holdings Limited (HKG:1026) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
The image below, which you can click on for greater detail, shows that Universal Technologies Holdings had debt of HK$452.2m at the end of December 2018, a reduction from HK$709.9m over a year. However, it does have HK$288.7m in cash offsetting this, leading to net debt of about HK$163.5m.
SEHK:1026 Historical Debt, August 29th 2019
How Strong Is Universal Technologies Holdings's Balance Sheet?
According to the last reported balance sheet, Universal Technologies Holdings had liabilities of HK$179.3m due within 12 months, and liabilities of HK$505.9m due beyond 12 months. On the other hand, it had cash of HK$288.7m and HK$28.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$367.7m.
Universal Technologies Holdings has a market capitalization of HK$1.05b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Universal Technologies Holdings has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 0.64. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Universal Technologies Holdings's EBIT was down 61% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Universal Technologies 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Universal Technologies Holdings 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.
Our View
To be frank both Universal Technologies 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. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. It's also worth noting that Universal Technologies Holdings is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Universal Technologies Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.
