Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Creative Realities, Inc. (NASDAQ:CREX) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Creative Realities Carry?
The image below, which you can click on for greater detail, shows that Creative Realities had debt of US$5.18m at the end of June 2019, a reduction from US$7.91m over a year. However, it does have US$1.82m in cash offsetting this, leading to net debt of about US$3.36m.
How Healthy Is Creative Realities's Balance Sheet?
According to the last reported balance sheet, Creative Realities had liabilities of US$13.3m due within 12 months, and liabilities of US$4.95m due beyond 12 months. On the other hand, it had cash of US$1.82m and US$6.32m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$10.1m.
Creative Realities has a market capitalization of US$19.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While we wouldn't worry about Creative Realities's net debt to EBITDA ratio of 2.6, we think its super-low interest cover of 0.10 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Creative Realities achieved a positive EBIT of US$173k in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Creative Realities 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Creative Realities burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Creative Realities's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, we think it's fair to say that Creative Realities has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Even though Creative Realities lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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