Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Electrocomponents plc (LON:ECM) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for Electrocomponents
What Is Electrocomponents’s Net Debt?
As you can see below, Electrocomponents had UK£259.5m of debt at March 2021, down from UK£335.3m a year prior. On the flip side, it has UK£197.9m in cash leading to net debt of about UK£61.6m.
How Strong Is Electrocomponents’ Balance Sheet?
According to the last reported balance sheet, Electrocomponents had liabilities of UK£631.0m due within 12 months, and liabilities of UK£316.7m due beyond 12 months. Offsetting this, it had UK£197.9m in cash and UK£488.8m in receivables that were due within 12 months. So its liabilities total UK£261.0m more than the combination of its cash and short-term receivables.
Of course, Electrocomponents has a market capitalization of UK£5.16b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Electrocomponents has a very light debt load indeed.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Electrocomponents’s net debt is only 0.32 times its EBITDA. And its EBIT easily covers its interest expense, being 25.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Electrocomponents’s EBIT dived 17%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Electrocomponents can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Electrocomponents recorded free cash flow of 49% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Both Electrocomponents’s ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. When we consider all the elements mentioned above, it seems to us that Electrocomponents is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 1 warning sign for Electrocomponents you should be aware of.
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.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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