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. 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 Cedar Woods Properties Limited (ASX:CWP) makes use of debt. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Cedar Woods Properties Carry?
The image below, which you can click on for greater detail, shows that Cedar Woods Properties had debt of AU$119.0m at the end of June 2019, a reduction from AU$133.0m over a year. However, it does have AU$13.4m in cash offsetting this, leading to net debt of about AU$105.6m.
How Healthy Is Cedar Woods Properties's Balance Sheet?
We can see from the most recent balance sheet that Cedar Woods Properties had liabilities of AU$54.2m falling due within a year, and liabilities of AU$141.0m due beyond that. Offsetting this, it had AU$13.4m in cash and AU$8.11m in receivables that were due within 12 months. So its liabilities total AU$173.6m more than the combination of its cash and short-term receivables.
Cedar Woods Properties has a market capitalization of AU$537.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Cedar Woods Properties has a low net debt to EBITDA ratio of only 1.5. And its EBIT covers its interest expense a whopping 29.5 times over. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Cedar Woods Properties grew its EBIT by 13% last year, making its debt load easier to handle. 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 Cedar Woods Properties'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Cedar Woods Properties reported free cash flow worth 8.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
When it comes to the balance sheet, the standout positive for Cedar Woods Properties was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Cedar Woods Properties's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Cedar Woods Properties's dividend history, without delay!
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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