Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried “. 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 can see that Australian Vintage Ltd (ASX: AVG) uses debt in its business. But should shareholders be concerned about its use of debt?
When is debt a problem?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. 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 think of a business’s use of debt, we first look at cash flow and debt together.
See our latest review for Australian Vintage
What is Australian Vintage’s net debt?
You can click on the graph below for historical figures, but it shows that Australian Vintage had A $ 59.9 million in debt as of December 2020, up from A $ 89.6 million a year earlier. However, because he has a cash reserve of A $ 7.92 million, his net debt is less, at around A $ 51.9 million.
How healthy is Australian Vintage’s balance sheet?
The latest balance sheet data shows Australian Vintage had A $ 51.8 million in liabilities due within one year and A $ 108.6 million in liabilities due thereafter. In return, he had A $ 7.92 million in cash and A $ 59.8 million in receivables due within 12 months. It therefore has a liability totaling AU $ 92.6 million more than its cash and short-term receivables combined.
Australian Vintage has a market cap of A $ 221.8 million, so it could most likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Australian Vintage has a net debt of only 1.4 times EBITDA, indicating that he is certainly not a reckless borrower. And this view is underpinned by the strong interest coverage, with EBIT standing at 9.0 times last year’s interest expense. On top of that, we are happy to report that Australian Vintage has increased its EBIT by 46%, reducing the specter of future debt repayments. There is no doubt that we learn the most about debt from the balance sheet. But ultimately the future profitability of the business will decide whether Australian Vintage can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years Australian Vintage has recorded free cash flow of 78% of its EBIT which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that Australian Vintage’s proven ability to increase their EBIT thrills us like a fluffy puppy does a toddler. And the good news does not end there, since its conversion of EBIT into free cash flow also confirms this impression! Zooming out, Australian Vintage appears to be using the debt fairly reasonably; and that gets the nod from us. After all, reasonable leverage can increase returns on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example – Australian Vintage a 1 warning sign we think you should be aware.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
When trading Australian Vintage or any other investment, use the platform considered by many to be the gateway for professionals to the global market, Interactive Brokers. You get the cheapest transactions * on stocks, options, futures, forex, bonds and funds from around the world from one integrated account.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
*Interactive Brokers Ranked Least Expensive Broker By StockBrokers.com Online Annual Review 2020
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.