Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that Acadian Timber Corp. (TSE:ADN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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. 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 Acadian Timber’s Net Debt?
As you can see below, Acadian Timber had CA$93.4m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had CA$20.9m in cash, and so its net debt is CA$72.5m.
A Look At Acadian Timber’s Liabilities
We can see from the most recent balance sheet that Acadian Timber had liabilities of CA$11.6m falling due within a year, and liabilities of CA$185.9m due beyond that. Offsetting this, it had CA$20.9m in cash and CA$7.03m in receivables that were due within 12 months. So its liabilities total CA$169.6m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CA$279.3m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
Acadian Timber has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 5.4 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Unfortunately, Acadian Timber saw its EBIT slide 6.9% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Acadian Timber’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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Acadian Timber recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
On our analysis Acadian Timber’s conversion of EBIT to free cash flow should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Acadian Timber’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. We’d be motivated to research the stock further if we found out that Acadian Timber insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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