Fuller Smith & Turner (LON:FSTA) Takes On Some Risk With Its Use Of Debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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. As with many other companies Fuller, Smith & Turner P.L.C. (LON:FSTA) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Fuller Smith & Turner
What Is Fuller Smith & Turner's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Fuller Smith & Turner had UK£257.6m of debt, an increase on UK£215.4m, over one year. However, because it has a cash reserve of UK£11.1m, its net debt is less, at about UK£246.5m.
A Look At Fuller Smith & Turner's Liabilities
Zooming in on the latest balance sheet data, we can see that Fuller Smith & Turner had liabilities of UK£112.9m due within 12 months and liabilities of UK£255.3m due beyond that. Offsetting this, it had UK£11.1m in cash and UK£5.30m in receivables that were due within 12 months. So it has liabilities totalling UK£351.8m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Fuller Smith & Turner has a market capitalization of UK£590.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 5.1, it's fair to say Fuller Smith & Turner does have a significant amount of debt. However, its interest coverage of 4.2 is reasonably strong, which is a good sign. Worse, Fuller Smith & Turner's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Fuller Smith & Turner can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, Fuller Smith & Turner produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
On the face of it, Fuller Smith & Turner's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Fuller Smith & Turner's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Over time, share prices tend to follow earnings per share, so if you're interested in Fuller Smith & Turner, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
