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 Adairs Limited (ASX:ADH) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Adairs's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Adairs had AU$25.0m of debt in December 2018, down from AU$29.9m, one year before. However, it does have AU$14.8m in cash offsetting this, leading to net debt of about AU$10.1m.
How Healthy Is Adairs's Balance Sheet?
The latest balance sheet data shows that Adairs had liabilities of AU$47.2m due within a year, and liabilities of AU$47.1m falling due after that. Offsetting these obligations, it had cash of AU$14.8m as well as receivables valued at AU$562.0k due within 12 months. So its liabilities total AU$78.8m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Adairs is worth AU$239.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Adairs has a low net debt to EBITDA ratio of only 0.19. And its EBIT easily covers its interest expense, being 35.2 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Adairs grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Adairs can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Adairs recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Adairs's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Adairs is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Adairs insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.