Is Brickworks (ASX:BKW) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Brickworks Limited (ASX:BKW) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Brickworks

How Much Debt Does Brickworks Carry?

The image below, which you can click on for greater detail, shows that at July 2023 Brickworks had debt of AU$712.0m, up from AU$594.7m in one year. However, it does have AU$70.0m in cash offsetting this, leading to net debt of about AU$642.0m.

How Strong Is Brickworks' Balance Sheet?

The latest balance sheet data shows that Brickworks had liabilities of AU$305.2m due within a year, and liabilities of AU$2.27b falling due after that. Offsetting these obligations, it had cash of AU$70.0m as well as receivables valued at AU$149.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.36b.

This deficit is considerable relative to its market capitalization of AU$3.77b, so it does suggest shareholders should keep an eye on Brickworks' use of debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.60 times and a disturbingly high net debt to EBITDA ratio of 9.2 hit our confidence in Brickworks like a one-two punch to the gut. The debt burden here is substantial. On a lighter note, we note that Brickworks grew its EBIT by 28% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Brickworks can strengthen its balance sheet over time. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Brickworks 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.

Our View

On the face of it, Brickworks's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Brickworks stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 3 warning signs we've spotted with Brickworks (including 1 which is a bit concerning) .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.