Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 note that ICO Group Limited (HKG:1460) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company’s use of debt, we first look at cash and debt together.
What Is ICO Group’s Debt?
As you can see below, at the end of March 2019, ICO Group had HK$60.4m of debt, up from HK$22.9m a year ago. Click the image for more detail. However, it does have HK$53.0m in cash offsetting this, leading to net debt of about HK$7.38m.
How Strong Is ICO Group’s Balance Sheet?
We can see from the most recent balance sheet that ICO Group had liabilities of HK$116.7m falling due within a year, and liabilities of HK$52.9m due beyond that. Offsetting these obligations, it had cash of HK$53.0m as well as receivables valued at HK$179.7m due within 12 months. So it can boast HK$63.1m more liquid assets than total liabilities.
It’s good to see that ICO Group has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don’t think it will have any issues with its lenders.
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 ICO Group’s low debt to EBITDA ratio of 0.20 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.8 last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Although ICO Group made a loss at the EBIT level, last year, it was also good to see that it generated HK$34m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since ICO Group will need earnings to service that debt. 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, ICO Group actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
ICO Group’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Considering this range of factors, it seems to us that ICO Group is quite prudent with its debt, and the risks seem well managed. So we’re not worried about the use of a little leverage on the balance sheet. We’d be very excited to see if ICO Group insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.
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