Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, North American Construction Group Ltd. (TSE:NOA) 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is North American Construction Group's Net Debt?
As you can see below, at the end of June 2019, North American Construction Group had CA$310.1m of debt, up from CA$131.2m a year ago. Click the image for more detail. However, because it has a cash reserve of CA$17.4m, its net debt is less, at about CA$292.7m.
How Healthy Is North American Construction Group's Balance Sheet?
We can see from the most recent balance sheet that North American Construction Group had liabilities of CA$177.7m falling due within a year, and liabilities of CA$423.6m due beyond that. Offsetting this, it had CA$17.4m in cash and CA$107.2m in receivables that were due within 12 months. So its liabilities total CA$476.6m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's CA$403.2m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). 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).
North American Construction Group's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 2.9 times last year. 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 is well worth noting that North American Construction Group's EBIT shot up like bamboo after rain, gaining 78% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if North American Construction Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, North American Construction Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We'd go so far as to say North American Construction Group's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that North American Construction Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given our hesitation about the stock, it would be good to know if North American Construction Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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