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.’ 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 Corsa Coal Corp. (CVE:CSO) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 Corsa Coal’s Debt?
The chart below, which you can click on for greater detail, shows that Corsa Coal had US$32.8m in debt in March 2019; about the same as the year before. However, because it has a cash reserve of US$10.4m, its net debt is less, at about US$22.5m.
A Look At Corsa Coal’s Liabilities
The latest balance sheet data shows that Corsa Coal had liabilities of US$47.9m due within a year, and liabilities of US$77.9m falling due after that. Offsetting this, it had US$10.4m in cash and US$24.3m in receivables that were due within 12 months. So its liabilities total US$91.2m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$52.9m 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’d watch its balance sheet closely, without a doubt After all, Corsa Coal would likely require a major re-capitalisation if it had to pay its creditors today. Either way, since Corsa Coal 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.
Corsa Coal has a very low debt to EBITDA ratio of 0.70 so it is strange to see weak interest coverage, with last year’s EBIT being only 1.10 times the interest expense. So one way or the other, it’s clear the debt levels are not trivial. Importantly, Corsa Coal’s EBIT fell a jaw-dropping 92% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Corsa Coal’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Corsa Coal recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Corsa Coal’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Considering all the factors previously mentioned, we think that Corsa Coal really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. Given our concerns about Corsa Coal’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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