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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.' 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. As with many other companies The Environmental Group Limited (ASX:EGL) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Environmental Group
What Is Environmental Group's Debt?
As you can see below, at the end of June 2019, Environmental Group had AU$1.99m of debt, up from none a year ago. Click the image for more detail. However, it does have AU$171.1k in cash offsetting this, leading to net debt of about AU$1.82m.
A Look At Environmental Group's Liabilities
We can see from the most recent balance sheet that Environmental Group had liabilities of AU$9.74m falling due within a year, and liabilities of AU$2.03m due beyond that. On the other hand, it had cash of AU$171.1k and AU$9.20m worth of receivables due within a year. So its liabilities total AU$2.39m more than the combination of its cash and short-term receivables.
Environmental Group has a market capitalization of AU$9.14m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.