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.' 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 note that United Overseas Australia Limited (ASX:UOS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does United Overseas Australia Carry?
You can click the graphic below for the historical numbers, but it shows that United Overseas Australia had AU$124.3m of debt in June 2020, down from AU$132.4m, one year before. But it also has AU$447.8m in cash to offset that, meaning it has AU$323.5m net cash.
How Strong Is United Overseas Australia's Balance Sheet?
According to the last reported balance sheet, United Overseas Australia had liabilities of AU$354.1m due within 12 months, and liabilities of AU$59.6m due beyond 12 months. On the other hand, it had cash of AU$447.8m and AU$245.6m worth of receivables due within a year. So it can boast AU$279.7m more liquid assets than total liabilities.
This excess liquidity suggests that United Overseas Australia is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, United Overseas Australia boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that United Overseas Australia has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is United Overseas Australia's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. United Overseas Australia may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, United Overseas Australia recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company's debt, in this case United Overseas Australia has AU$323.5m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of AU$193m, being 86% of its EBIT. So is United Overseas Australia's debt a risk? It doesn't seem so to us. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with United Overseas Australia , and understanding them should be part of your investment process.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
This article by Simply Wall St is general in nature. 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.
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