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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Educational Development Corporation (NASDAQ:EDUC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 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 Educational Development's Debt?
As you can see below, Educational Development had US$19.5m of debt at May 2019, down from US$20.5m a year prior. However, it also had US$1.40m in cash, and so its net debt is US$18.1m.
A Look At Educational Development's Liabilities
According to the last reported balance sheet, Educational Development had liabilities of US$20.2m due within 12 months, and liabilities of US$19.6m due beyond 12 months. Offsetting this, it had US$1.40m in cash and US$3.08m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$35.3m.
This deficit is considerable relative to its market capitalization of US$52.1m, so it does suggest shareholders should keep an eye on Educational Development's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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 1.9, Educational Development uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. We saw Educational Development grow its EBIT by 2.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Educational Development will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Educational Development recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Educational Development's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But it seems to be able to cover its interest expense with its EBIT without much trouble. We think that Educational Development's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Educational Development insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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