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 note that Avarga Limited (SGX:U09) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for Avarga

What Is Avarga's Debt?

As you can see below, Avarga had S$199.7m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have S$14.7m in cash offsetting this, leading to net debt of about S$185.0m.

How Healthy Is Avarga's Balance Sheet?

According to the last reported balance sheet, Avarga had liabilities of S$262.7m due within 12 months, and liabilities of S$159.2m due beyond 12 months. Offsetting these obligations, it had cash of S$14.7m as well as receivables valued at S$194.2m due within 12 months. So it has liabilities totalling S$212.8m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's S$177.1m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.