The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Electrocomponents
What Is Electrocomponents’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Electrocomponents had UK£259.5m of debt in March 2021, down from UK£335.3m, one year before. However, it does have UK£197.9m in cash offsetting this, leading to net debt of about UK£61.6m.
How Strong Is Electrocomponents’ Balance Sheet?
The latest balance sheet data shows that Electrocomponents had liabilities of UK£631.0m due within a year, and liabilities of UK£316.7m falling due after that. On the other hand, it had cash of UK£197.9m and UK£488.8m worth of receivables due within a year. So it has liabilities totalling UK£261.0m more than its cash and near-term receivables, combined.
Given Electrocomponents has a market capitalization of UK£4.85b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, Electrocomponents has a very light debt load indeed.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Electrocomponents has a low net debt to EBITDA ratio of only 0.32. And its EBIT covers its interest expense a whopping 25.8 times over. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Electrocomponents has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Electrocomponents’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Electrocomponents’s free cash flow amounted to 49% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Electrocomponents’s interest cover was a real positive on this analysis, as was its net debt to EBITDA. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Considering this range of data points, we think Electrocomponents is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. We’ve identified 1 warning sign with Electrocomponents , and understanding them should be part of your investment process.
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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