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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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. As with many other companies Far East Orchard Limited (SGX:O10) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
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What Is Far East Orchard's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Far East Orchard had debt of S$407.0m, up from S$257.3m in one year. However, because it has a cash reserve of S$260.5m, its net debt is less, at about S$146.5m.
A Look At Far East Orchard's Liabilities
The latest balance sheet data shows that Far East Orchard had liabilities of S$547.4m due within a year, and liabilities of S$565.9m falling due after that. On the other hand, it had cash of S$260.5m and S$24.5m worth of receivables due within a year. So it has liabilities totalling S$828.3m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the S$508.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt After all, Far East Orchard would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).