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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We note that Bapcor Limited (ASX: BAP) has debt on its balance sheet. But the most important question is: what risk does this debt create?
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Bapcor’s debt?
The image below, which you can click for more details, shows Bapcor owed AUS $ 204.2 million at the end of June 2021, a reduction from A $ 229.1 million on a year. On the other hand, he has A $ 39.6 million in cash, resulting in net debt of around A $ 164.6 million.
How strong is Bapcor’s balance sheet?
According to the latest published balance sheet, Bapcor had a liability of A $ 363.7 million due within 12 months and a liability of A $ 382.3 million due beyond 12 months. On the other hand, he had A $ 39.6 million in cash and A $ 181.4 million in receivables due within one year. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by AU $ 525.0 million.
While that might sound like a lot, it’s not that big of a deal since Bapcor has a market cap of AU $ 2.44 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Bapcor has a low net debt to EBITDA ratio of just 0.76. And its EBIT covers its interest costs 13.1 times more. So we’re pretty relaxed about its ultra-conservative use of debt. On top of that, we are happy to report that Bapcor has increased its EBIT by 45%, reducing the specter of future debt repayments. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Bapcor can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Bapcor has recorded free cash flow of 58% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that Bapcor’s demonstrated ability to cover interest costs with EBIT delights us like a fluffy puppy does a toddler. And that’s just the start of good news as its EBIT growth rate is also very encouraging. By zooming out, Bapcor seems to be using the debt in a very reasonable way; and that gets the nod from us. After all, reasonable leverage can increase returns on equity. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. Note that Bapcor shows 1 warning sign in our investment analysis , you must know…
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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