Legendary fund manager Li Lu (who was backed by Charlie Munger) once said, “The biggest investment risk isn’t the volatility of prices, it’s whether you suffer a permanent loss of capital.” When we think about how risky a company is, we always look gladly on the use of debt, as over-indebtedness can lead to ruin. Important, WH Group Limited (HKG:288) is in debt. But is that debt a problem for shareholders?
When is debt a problem?
Debt helps a business until the business struggles to pay it back, either with new capital or free cash flow. If things get really bad, lenders can take control of the deal. A more common (but still costly) case, however, is when a company has to issue stock at bargain prices, which permanently dilutes shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive ones. The first thing to do when considering how much debt a company uses is to look at its cash and debt together.
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How much debt does the WH Group carry?
As you can see below, WH Group had $3.89 billion in debt at the end of June 2022, up from $2.85 billion a year earlier. Click on the picture for more details. However, it also had $1.06 billion in cash, making its net debt $2.83 billion.
How healthy is WH Group’s balance sheet?
The most recent balance sheet shows that WH Group had $4.63 billion in liabilities that matured within one year and $5.21 billion in liabilities that matured beyond that were. Against these obligations, the company had $1.06 billion in cash and $1.30 billion of accounts receivable that were due within 12 months. So it has total liabilities of $7.48 billion, more than its cash and short-term receivables combined.
That’s a mountain of leverage relative to its $9.46 billion market cap. This suggests that if the company needed to bolster its balance sheet quickly, shareholders would be severely diluted.
We measure a company’s debt burden relative to its profitability by dividing its net debt by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how well its earnings before interest and taxes (EBIT) are covering its interest costs (interest coverage) . In this way, we take into account both the absolute amount of the debt and the interest paid on it.
WH Group’s net debt is only 1.1 times its EBITDA. And its EBIT, which is 17.1 times the size, easily covers its interest expenses. So we’re pretty relaxed about the super-conservative use of debt. Additionally, WH Group grew its EBIT by 65% over the last 12 months, and that growth will make it easier to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will determine whether WH Group can strengthen its balance sheet over time. So if you want to see what the experts think, you might be interested in this free report on analyst earnings forecasts.
After all, a company can only pay off debts with hard cash, not with accounting profits. So we always check how much of that EBIT translates into free cash flow. Over the past three years, WH Group has generated robust free cash flow equivalent to 54% of its EBIT, which is roughly in line with our expectations. This cold, hard money means they can reduce their debt whenever they want.
Fortunately, WH Group’s impressive interest coverage implies that it has the upper hand on its debt. But, to add murkiness, we’re a little worried about the level of total debt. When we look at all of the above factors together, what strikes us is that WH Group is pretty comfortable managing its debt. While this leverage can improve return on equity, it obviously comes with more risk, so it’s worth keeping an eye on. When analyzing debt, the balance sheet is the obvious place to start. But ultimately, any business can have off-balance-sheet risks. We have identified 2 warning signs with WH Group and understanding them should be part of your investment process.
Of course, if you’re one of those investors who prefer to buy stocks without the burden of debt, don’t hesitate to explore our exclusive list of net cash growth stocks today.
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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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