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. Importantly, The Chefs' Warehouse, Inc. (NASDAQ:CHEF) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Chefs' Warehouse's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Chefs' Warehouse had US$280.3m of debt in June 2019, down from US$316.6m, one year before. However, it does have US$24.3m in cash offsetting this, leading to net debt of about US$256.0m.
How Healthy Is Chefs' Warehouse's Balance Sheet?
According to the last reported balance sheet, Chefs' Warehouse had liabilities of US$139.2m due within 12 months, and liabilities of US$421.1m due beyond 12 months. On the other hand, it had cash of US$24.3m and US$157.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$378.6m.
While this might seem like a lot, it is not so bad since Chefs' Warehouse has a market capitalization of US$1.17b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Chefs' Warehouse's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a slightly more positive note, Chefs' Warehouse grew its EBIT at 17% over the last year, further increasing its ability to manage debt. 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 Chefs' Warehouse 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chefs' Warehouse produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
We weren't impressed with Chefs' Warehouse's net debt to EBITDA, and its interest cover made us cautious. On the other hand, we found comfort in its relatively strong EBIT growth rate. When we consider all the elements mentioned above, it seems to us that Chefs' Warehouse is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Chefs' Warehouse 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.
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 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.