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.’ 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 Exchange Income Corporation (TSE:EIF) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Exchange Income’s Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Exchange Income had debt of CA$1.12b, up from CA$1.04b in one year. However, it also had CA$66.2m in cash, and so its net debt is CA$1.06b.
How Strong Is Exchange Income’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Exchange Income had liabilities of CA$265.3m due within 12 months and liabilities of CA$1.33b due beyond that. Offsetting these obligations, it had cash of CA$66.2m as well as receivables valued at CA$268.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$1.3b.
Given this deficit is actually higher than the company’s market capitalization of CA$1.13b, we think shareholders really should watch Exchange Income’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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).
While we wouldn’t worry about Exchange Income’s net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 2.1 times is a sign of high leverage. In large part that’s due to the company’s significant…
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