Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Corsa Coal Corp. (CVE:CSO) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Corsa Coal's Debt?
You can click the graphic below for the historical numbers, but it shows that Corsa Coal had US$27.9m of debt in June 2019, down from US$34.9m, one year before. However, it does have US$14.9m in cash offsetting this, leading to net debt of about US$13.0m.
How Healthy Is Corsa Coal's Balance Sheet?
According to the last reported balance sheet, Corsa Coal had liabilities of US$49.5m due within 12 months, and liabilities of US$74.9m due beyond 12 months. Offsetting these obligations, it had cash of US$14.9m as well as receivables valued at US$20.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$88.5m.
The deficiency here weighs heavily on the US$39.3m 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, Corsa Coal would probably need a major re-capitalization if its creditors were to demand repayment.
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.
While Corsa Coal's low debt to EBITDA ratio of 0.34 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that Corsa Coal's EBIT was down 72% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Corsa Coal 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Corsa Coal reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
To be frank both Corsa Coal's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Corsa Coal has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Corsa Coal's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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.
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