E & M Computing (TLV:EMCO) appears to be using debt reasonably enough

Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu makes no secret when he says “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital.” It’s natural to consider a company’s balance sheet when examining how risky it is, as debt is often involved when a company fails. Importantly E&M Computing Ltd. (TLV:EMCO) carries debt. But does this debt worry shareholders?

What risk does debt carry?

In general, debt only becomes a real problem when a company can’t pay it off easily, either with capital raising or with its own free cash flow. Integral to capitalism is the process of “creative destruction” in which failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thereby permanently diluting shareholders. That said, the most common situation is where a business manages its debt reasonably well and for its own benefit. The first thing to do when considering how much debt a business is using is to look at cash and debt together.

View our latest analysis for E&M Computing

What is E&M Computing’s debt?

As you can see below, at the end of March 2023, E&M Computing was $207.0 million in debt, up from $177.1 million a year ago. Click the image for more details. On the flip side, it has $59.9 million in cash leading to a net debt of about $147.1 million.

How strong is E&M Computing’s balance sheet?

The latest balance sheet data shows that E & M Computing had $517.3 million in debt due within a year and $144.1 million in debt due later. To offset this, it had $59.9 million in cash and $466.9 million in receivables due within 12 months. So its liabilities total $134.6 million more than the combination of cash and accounts receivable.

This shortfall isn’t that bad because E&M Computing is worth $388.7 million, and therefore could likely raise enough capital to shore up its balance sheet if the need arose. But we definitely want to keep an eye out for indications that your debt is carrying too much risk.

To evaluate a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its spending for interest (your interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt relative to EBITDA) and the effective interest expense associated with that debt (with its interest coverage ratio).

E & M Computing has net debt of 2.3 times EBITDA, which isn’t excessive, but its interest coverage seems a little low, with EBIT at just 6.3 times interest expense. While these numbers don’t alarm us, it’s worth noting that the company’s cost of debt is having a real impact. It’s worth noting that E&M Computing’s EBIT is up like bamboo after rain, gaining 39% over the past twelve months. This will make managing your debt easier. When analyzing debt levels, the balance sheet is the obvious place to start. But you can’t see debt in isolation; as E&M Computing will need earnings to service that debt. So when you look at debt, it’s definitely worth looking at earnings performance. 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 the logical step is to look at the proportion of that EBIT that is actual free cash flow. Over the past three years, E&M Computing has reported free cash flow equal to 98% of its EBIT, which is stronger than we’d usually expect. This puts it in a very strong position to pay down the debt.

Our point of view

E&M Computing’s conversion of EBIT to free cash flow suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an under-14 goalkeeper. And the good news doesn’t stop there, as even its EBIT growth rate confirms this impression! When we consider the above range of factors, it appears that E&M Computing is quite reasonable with its use of debt. That means they are taking on a little more risk, in hopes of boosting shareholder returns. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, every business may contain risks that exist off the balance sheet. These risks can be difficult to spot. Every company has them, and we’ve spotted them 4 Warning Signs for E&M Computing (of which 1 is a bit nasty!) that you should know.

If, after all that, you’re more interested in a fast-growing company with a rock-solid balance sheet, be sure to check out our list of stocks with net cash growth.

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