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. Importantly, Alimentation Couche-Tard Inc. (TSE:ATD.B) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Alimentation Couche-Tard's Debt?
The image below, which you can click on for greater detail, shows that Alimentation Couche-Tard had debt of US$6.73b at the end of July 2019, a reduction from US$8.60b over a year. On the flip side, it has US$1.06b in cash leading to net debt of about US$5.67b.
A Look At Alimentation Couche-Tard's Liabilities
The latest balance sheet data shows that Alimentation Couche-Tard had liabilities of US$5.86b due within a year, and liabilities of US$9.91b falling due after that. Offsetting this, it had US$1.06b in cash and US$2.10b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$12.6b.
While this might seem like a lot, it is not so bad since Alimentation Couche-Tard has a huge market capitalization of US$35.1b, 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 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a debt to EBITDA ratio of 1.6, Alimentation Couche-Tard uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.6 times interest expense) certainly does not do anything to dispel this impression. Also good is that Alimentation Couche-Tard grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alimentation Couche-Tard'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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Alimentation Couche-Tard produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Alimentation Couche-Tard's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its interest cover is also very heartening. All these things considered, it appears that Alimentation Couche-Tard can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Alimentation Couche-Tard insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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