The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Gallant Venture Ltd. (SGX:5IG) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Gallant Venture's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2024 Gallant Venture had S$421.2m of debt, an increase on S$358.5m, over one year. However, because it has a cash reserve of S$83.4m, its net debt is less, at about S$337.8m.
A Look At Gallant Venture's Liabilities
The latest balance sheet data shows that Gallant Venture had liabilities of S$251.2m due within a year, and liabilities of S$446.5m falling due after that. Offsetting these obligations, it had cash of S$83.4m as well as receivables valued at S$62.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$551.6m.
Given this deficit is actually higher than the company's market capitalization of S$393.3m, we think shareholders really should watch Gallant Venture's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Gallant Venture shareholders face the double whammy of a high net debt to EBITDA ratio (7.8), and fairly weak interest coverage, since EBIT is just 0.52 times the interest expense. This means we'd consider it to have a heavy debt load. Given the debt load, it's hardly ideal that Gallant Venture's EBIT was pretty flat over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Gallant Venture's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Gallant Venture saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
To be frank both Gallant Venture's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that Gallant Venture is in the Integrated Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Gallant Venture has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Gallant Venture you should be aware of, and 1 of them is potentially serious.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.