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David Iben expressed it well when he said: “Volatility is not a risk that is close to our hearts. What matters to us is to avoid the permanent loss of capital. ‘ So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Overseas Trade Ltd. (TLV: OVRS) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider both liquidity and debt levels.
See our latest analysis for overseas trade
How much debt does foreign trade carry?
You can click on the graph below for historical figures, but it shows that Overseas Commerce had 128.9 million yen in debt in March 2021, up from 140.2 million yen a year earlier. However, it has € 12.5 million in cash offsetting this, leading to net debt of around € 116.5 million.
A look at the responsibilities of overseas trade
We can see from the most recent balance sheet that Overseas Commerce had liabilities of 113.6 million yen due within one year and liabilities of 315.7 million yen beyond. In return, he had 12.5 million cash and 73.5 million receivables due within 12 months. Its liabilities are therefore 343.4 million more than the combination of its cash and short-term receivables.
When you consider that this deficit exceeds the company’s 247.1 million yen market capitalization, you might well be inclined to take a close look at the balance sheet. In the event that the company were to clean up its balance sheet quickly, it seems likely that shareholders would suffer significant dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Overseas Commerce has net debt of 2.0 times EBITDA, which is not too much, but its interest coverage seems a bit weak, with EBIT at just 3.7 times interest expense. While this doesn’t worry us too much, it does suggest that the interest payments are somewhat of a burden. Overseas Commerce has increased its EBIT by 2.9% over the past year. It’s far from incredible, but it’s a good thing when it comes to paying down debt. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in isolation; since Overseas Commerce will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business can only repay its debts with hard cash, not with book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Overseas Commerce has actually generated more free cash flow than EBIT. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
The level of Overseas Commerce’s total liabilities and interest coverage certainly weighs on this, in our view. But its conversion from EBIT to free cash flow tells a very different story and suggests some resilience. It should also be noted that overseas trade belongs to the infrastructure sector, which is often seen as quite defensive. Taking the above factors together, we believe that Overseas Commerce debt presents certain risks to the business. While this debt may increase returns, we believe the company now has sufficient leverage. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 4 warning signs for overseas trade (1 of which doesn’t suit us very well!) you should know that.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, don’t hesitate to check out our exclusive list of cash-flow-growing stocks today.
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