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Is This Company Facing Hard Times Ahead?

There’s a common saying that leverage is a double-edged sword. When times are good, leverage can help a company boost its returns. However, when times are bad, leverage can be deadly. There have been discussions about whether interest rates would rise in the future and that’s an important topic to think about when it comes to companies with debt-ridden balance sheets.

For investors in highly-geared Aspial Corporation (SGX: A30), would tougher times be ahead?

What’s behind Aspial

Aspial is a conglomerate that is perhaps well-known for its huge network of jewellery chains such as Aspial, Lee Hwa, Goldheart, and Citigems. It is also a major property developer in Singapore as well as the majority shareholder of Maxi-Cash Financial Services Corp Ltd (SGX: 5UF), a leader in the pawn-broking business in Singapore.

In a bid to grow its business over the last few years, Aspial has financed its expansion largely with debt, causing its balance sheet to become highly geared. As of 30 June 2014, Aspial holds more than S$1.0 billion in debt compared to shareholder’s equity of S$368.6 million.

Those borrowings are not easy to service. For instance, Aspial spent more than S$10 million in finance costs in the first half of this year when its operating profit was just S$6.6 million.

After the Global Financial Crisis of 2007-09, Aspial experienced a great bull run in its share price (a 377% gain in the five years ending 13 October 2014) as leverage helped the company to expand rapidly and boosted its earnings. So, the borrowings have been very helpful for Aspial.

But the issue with debt is that it would need to be repaid sooner or later.

Debt can only be paid back by a company using cash flow from four main sources: 1) From its business operations; 2) from the sale of assets; 3) from more debt; and 4) from raising equity capital.

Some companies, such as Dairy Farm International Holdings Ltd (SGX: D01) and Singapore Telecommunications Limited (SGX: Z74), have businesses which generates very strong and stable cash flows. Such companies might then be able to use the cash flow to pay back their borrowings or reinvest in their business.

The problem with Aspial is that it operates in three capital intensive business segments which generate very little cash flow. Its jewellery business requires huge reinvestment into inventory to grow; its property business requires cash to be reinvested constantly to maintain the company’s land bank; and its pawn-broking business requires cash to be deployed to earn interest from providing loans. As such, Aspial might have difficulty repaying its borrowings using its cash flow from operations without significantly slowing down its business expansion.

Aspial might be able to consider selling off its assets to pay down its borrowings. It is certainly doable but shareholders must be prepared to own a company with a smaller asset base after any sale. Furthermore, Aspial’s future earnings might even be affected if a useful asset is sold.

Another option for Aspial would be to borrow from elsewhere to repay any of its maturing obligations – that’s in effect a refinancing of its borrowings – but it is merely an act of kicking the can down the road.

The last option would see Aspial raise equity capital (by selling new shares or issuing rights) to pay off its borrowings. But that’s an act which can be massively dilutive for existing shareholders.

Foolish Take

So, as you can see, none of the four options are desirable for Aspial. But, the question still remains: How would Aspial plan to repay its borrowings if or when interest rates rises or the economy slows down?

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.