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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. We note that Franklin Covey Co. (NYSE:FC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Franklin Covey's Net Debt?
As you can see below, Franklin Covey had US$17.5m of debt at February 2021, down from US$22.5m a year prior. But it also has US$40.3m in cash to offset that, meaning it has US$22.8m net cash.
A Look At Franklin Covey's Liabilities
According to the last reported balance sheet, Franklin Covey had liabilities of US$101.1m due within 12 months, and liabilities of US$38.6m due beyond 12 months. On the other hand, it had cash of US$40.3m and US$41.5m worth of receivables due within a year. So its liabilities total US$57.9m more than the combination of its cash and short-term receivables.
Of course, Franklin Covey has a market capitalization of US$415.0m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Franklin Covey also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, Franklin Covey's EBIT fell a jaw-dropping 25% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Franklin Covey'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, a company can only pay off debt with cold hard cash, not accounting profits. Franklin Covey may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Franklin Covey actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Although Franklin Covey's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$22.8m. The cherry on top was that in converted 499% of that EBIT to free cash flow, bringing in US$30m. So we are not troubled with Franklin Covey's debt use. While Franklin Covey didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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