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. We note that Cervus Equipment Corporation (TSE:CERV) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Cervus Equipment's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Cervus Equipment had debt of CA$339.2m, up from CA$252.2m in one year. And it doesn't have much cash, so its net debt is about the same.
A Look At Cervus Equipment's Liabilities
Zooming in on the latest balance sheet data, we can see that Cervus Equipment had liabilities of CA$283.3m due within 12 months and liabilities of CA$138.3m due beyond that. On the other hand, it had cash of CA$2.56m and CA$69.5m worth of receivables due within a year. So it has liabilities totalling CA$349.6m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CA$165.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Cervus Equipment would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Cervus Equipment has a rather high debt to EBITDA ratio of 5.8 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.1 times, suggesting it can responsibly service its obligations. If Cervus Equipment can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Cervus Equipment can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Cervus Equipment reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Cervus Equipment's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Cervus Equipment's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given the risks around Cervus Equipment's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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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.