David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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 Clover Corporation Limited (ASX:CLV) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Clover's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2019 Clover had AU$13.5m of debt, an increase on AU$4.19m, over one year. However, it does have AU$8.27m in cash offsetting this, leading to net debt of about AU$5.19m.
How Healthy Is Clover's Balance Sheet?
According to the last reported balance sheet, Clover had liabilities of AU$17.6m due within 12 months, and liabilities of AU$12.0m due beyond 12 months. Offsetting this, it had AU$8.27m in cash and AU$18.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.89m.
This state of affairs indicates that Clover's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the AU$537.2m company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Clover has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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.
Clover has net debt of just 0.38 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. In addition to that, we're happy to report that Clover has boosted its EBIT by 33%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Clover 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Clover reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Happily, Clover's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think Clover's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Clover insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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