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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Metcash Limited (ASX:MTS) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Metcash
What Is Metcash's Net Debt?
As you can see below, at the end of April 2019, Metcash had AU$178.1m of debt, up from AU$129.0m a year ago. Click the image for more detail. On the flip side, it has AU$143.0m in cash leading to net debt of about AU$35.1m.
How Healthy Is Metcash's Balance Sheet?
According to the last reported balance sheet, Metcash had liabilities of AU$2.11b due within 12 months, and liabilities of AU$302.7m due beyond 12 months. On the other hand, it had cash of AU$143.0m and AU$1.49b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$780.3m.
Metcash has a market capitalization of AU$2.75b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, Metcash has a very light debt load indeed.
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).