Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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 Cogeco Inc. (TSE:CGO) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Cogeco’s Net Debt?
The image below, which you can click on for greater detail, shows that Cogeco had debt of CA$3.51b at the end of August 2019, a reduction from CA$3.90b over a year. However, because it has a cash reserve of CA$559.4m, its net debt is less, at about CA$2.95b.
How Strong Is Cogeco’s Balance Sheet?
The latest balance sheet data shows that Cogeco had liabilities of CA$403.2m due within a year, and liabilities of CA$4.10b falling due after that. Offsetting these obligations, it had cash of CA$559.4m as well as receivables valued at CA$117.1m due within 12 months. So it has liabilities totalling CA$3.82b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CA$1.65b 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, Cogeco would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cogeco has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 3.6 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Fortunately, Cogeco grew its EBIT by 7.8% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Cogeco’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Cogeco recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Mulling over Cogeco’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Once we consider all the factors above, together, it seems to us that Cogeco’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Cogeco insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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