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. We can see that Exchange Income Corporation (TSE:EIF) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Exchange Income’s Net Debt?
The image below, which you can click on for greater detail, shows that at March 2020 Exchange Income had debt of CA$1.21b, up from CA$1.02b in one year. However, it does have CA$118.2m in cash offsetting this, leading to net debt of about CA$1.09b.
A Look At Exchange Income’s Liabilities
The latest balance sheet data shows that Exchange Income had liabilities of CA$284.9m due within a year, and liabilities of CA$1.43b falling due after that. Offsetting these obligations, it had cash of CA$118.2m as well as receivables valued at CA$305.4m due within 12 months. So it has liabilities totalling CA$1.29b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of CA$1.01b, 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Exchange Income’s debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 2.5 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it…
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