The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Alimentation Couche-Tard Inc. (TSE:ATD.B) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Alimentation Couche-Tard Carry?
As you can see below, Alimentation Couche-Tard had US$7.21b of debt at April 2019, down from US$9.08b a year prior. However, it also had US$706.4m in cash, and so its net debt is US$6.50b.
How Healthy Is Alimentation Couche-Tard’s Balance Sheet?
According to the last reported balance sheet, Alimentation Couche-Tard had liabilities of US$5.58b due within 12 months, and liabilities of US$7.84b due beyond 12 months. Offsetting this, it had US$706.4m in cash and US$2.03b in receivables that were due within 12 months. So its liabilities total US$10.7b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Alimentation Couche-Tard is worth a massive US$34.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Either way, since Alimentation Couche-Tard does have more debt than cash, it’s worth keeping an eye on its balance sheet.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.85, Alimentation Couche-Tard uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.33 times its interest expenses harmonizes with that theme. Also relevant is that Alimentation Couche-Tard has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down debt. 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 Alimentation Couche-Tard’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Alimentation Couche-Tard produced sturdy free cash flow equating to 60% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Alimentation Couche-Tard’s impressive EBIT growth rate implies it has the upper hand on its debt. And its interest cover is good too. All these things considered, it appears that Alimentation Couche-Tard can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Alimentation Couche-Tard insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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