Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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 can see that Finbar Group Limited (ASX:FRI) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Finbar Group Carry?
As you can see below, at the end of June 2019, Finbar Group had AU$79.6m of debt, up from AU$55.9m a year ago. Click the image for more detail. On the flip side, it has AU$48.5m in cash leading to net debt of about AU$31.1m.
How Healthy Is Finbar Group’s Balance Sheet?
The latest balance sheet data shows that Finbar Group had liabilities of AU$79.1m due within a year, and liabilities of AU$51.0m falling due after that. Offsetting this, it had AU$48.5m in cash and AU$18.4m in receivables that were due within 12 months. So it has liabilities totalling AU$63.1m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Finbar Group is worth AU$238.1m, 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.
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.
We’d say that Finbar Group’s moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. The bad news is that Finbar Group saw its EBIT decline by 18% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is Finbar Group’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. Looking at the most recent three years, Finbar Group recorded free cash flow of 27% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Neither Finbar Group’s ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Finbar Group’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 3 warning signs with Finbar Group (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.
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.
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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