Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Restore plc (LON:RST) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Restore's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Restore had UK£123.3m of debt, an increase on UK£89.2m, over one year. However, it also had UK£11.7m in cash, and so its net debt is UK£111.6m.
How Strong Is Restore's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Restore had liabilities of UK£37.8m due within 12 months and liabilities of UK£145.0m due beyond that. On the other hand, it had cash of UK£11.7m and UK£34.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£137.0m.
Restore has a market capitalization of UK£513.5m, 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 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).
Restore's net debt of 2.4 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.8 times its interest expenses harmonizes with that theme. If Restore can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Restore'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.
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. In the last three years, Restore's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Both Restore's ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. Considering this range of data points, we think Restore is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Restore insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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