David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Frontier Services Group Limited (HKG:500) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Frontier Services Group
What Is Frontier Services Group's Debt?
As you can see below, at the end of June 2024, Frontier Services Group had HK$219.1m of debt, up from HK$199.6m a year ago. Click the image for more detail. However, it also had HK$201.8m in cash, and so its net debt is HK$17.2m.
How Healthy Is Frontier Services Group's Balance Sheet?
The latest balance sheet data shows that Frontier Services Group had liabilities of HK$490.8m due within a year, and liabilities of HK$35.7m falling due after that. Offsetting this, it had HK$201.8m in cash and HK$287.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$37.0m.
Since publicly traded Frontier Services Group shares are worth a total of HK$490.3m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Frontier Services Group's low debt to EBITDA ratio of 0.19 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Frontier Services Group improved its EBIT from a last year's loss to a positive HK$65m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Frontier Services Group will need earnings to service that debt. 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. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Frontier Services Group recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
When it comes to the balance sheet, the standout positive for Frontier Services Group was the fact that it seems able handle its debt, based on its EBITDA, confidently. But the other factors we noted above weren't so encouraging. For example, its interest cover makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Frontier Services Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Frontier Services Group is showing 4 warning signs in our investment analysis , you should know about...
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.
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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.