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. 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. As with many other companies American Outdoor Brands Corporation (NASDAQ:AOBC) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is American Outdoor Brands's Debt?
The image below, which you can click on for greater detail, shows that American Outdoor Brands had debt of US$179.3m at the end of July 2019, a reduction from US$194.6m over a year. However, it does have US$30.7m in cash offsetting this, leading to net debt of about US$148.5m.
How Healthy Is American Outdoor Brands's Balance Sheet?
The latest balance sheet data shows that American Outdoor Brands had liabilities of US$164.4m due within a year, and liabilities of US$164.9m falling due after that. Offsetting this, it had US$30.7m in cash and US$72.4m in receivables that were due within 12 months. So its liabilities total US$226.3m more than the combination of its cash and short-term receivables.
American Outdoor Brands has a market capitalization of US$377.7m, so it could very likely raise cash to ameliorate 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
American Outdoor Brands has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. The bad news is that American Outdoor Brands saw its EBIT decline by 20% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine American Outdoor Brands's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, American Outdoor Brands recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say American Outdoor Brands's EBIT growth rate was disappointing. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that American Outdoor Brands has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of American Outdoor Brands's earnings per share history for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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