Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 Big 5 Sporting Goods Corporation (NASDAQ:BGFV) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Big 5 Sporting Goods’s Debt?
The image below, which you can click on for greater detail, shows that Big 5 Sporting Goods had debt of US$60.6m at the end of September 2019, a reduction from US$83.5m over a year. However, it does have US$5.04m in cash offsetting this, leading to net debt of about US$55.6m.
How Strong Is Big 5 Sporting Goods’s Balance Sheet?
The latest balance sheet data shows that Big 5 Sporting Goods had liabilities of US$219.2m due within a year, and liabilities of US$292.9m falling due after that. On the other hand, it had cash of US$5.04m and US$10.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$496.8m.
The deficiency here weighs heavily on the US$76.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Big 5 Sporting Goods would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Big 5 Sporting Goods has net debt worth 2.1 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 2.5 times the interest expense. 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. Pleasingly, Big 5 Sporting Goods is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 354% gain in the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Big 5 Sporting Goods will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Big 5 Sporting Goods’s free cash flow amounted to 24% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We’d go so far as to say Big 5 Sporting Goods’s level of total liabilities was disappointing. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the bigger picture, it seems clear to us that Big 5 Sporting Goods’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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 4 warning signs for Big 5 Sporting Goods you should be aware of, and 1 of them is concerning.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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