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 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. Importantly, JB Foods Limited (SGX:BEW) does carry debt. 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. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is JB Foods’s Net Debt?
As you can see below, at the end of June 2020, JB Foods had US$145.5m of debt, up from US$111.8m a year ago. Click the image for more detail. However, it does have US$23.4m in cash offsetting this, leading to net debt of about US$122.1m.
How Healthy Is JB Foods’s Balance Sheet?
The latest balance sheet data shows that JB Foods had liabilities of US$170.4m due within a year, and liabilities of US$12.3m falling due after that. Offsetting this, it had US$23.4m in cash and US$55.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$103.7m.
This is a mountain of leverage relative to its market capitalization of US$126.3m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
JB Foods’s debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.8 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Unfortunately, JB Foods saw its EBIT slide 4.9% 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. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since JB Foods will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, JB Foods saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over JB Foods’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn’t such a worry. We’re quite clear that we consider JB Foods to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 2 warning signs for JB Foods (1 is a bit concerning) you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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