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Charlotte's Web Holdings (TSE:CWEB) Takes On Some Risk With Its Use Of Debt

Simply Wall St

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Charlotte's Web Holdings, Inc. (TSE:CWEB) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Charlotte's Web Holdings

What Is Charlotte's Web Holdings's Debt?

As you can see below, Charlotte's Web Holdings had US$16.0k of debt at June 2019, down from US$568.0k a year prior. However, it does have US$51.4m in cash offsetting this, leading to net cash of US$51.4m.

TSX:CWEB Historical Debt, August 28th 2019

How Healthy Is Charlotte's Web Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Charlotte's Web Holdings had liabilities of US$14.0m due within 12 months and liabilities of US$8.32m due beyond that. Offsetting these obligations, it had cash of US$51.4m as well as receivables valued at US$15.5m due within 12 months. So it can boast US$44.6m more liquid assets than total liabilities.

This surplus suggests that Charlotte's Web Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Charlotte's Web Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Charlotte's Web Holdings's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Charlotte's Web Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Charlotte's Web Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Charlotte's Web Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Charlotte's Web Holdings has net cash of US$51m, as well as more liquid assets than liabilities. So while Charlotte's Web Holdings does not have a great balance sheet, it's certainly not too bad. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.