Stock Analysis

Is Circa Enterprises (CVE:CTO) A Risky Investment?

TSXV:CTO
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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Circa Enterprises Inc. (CVE:CTO) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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.

Check out our latest analysis for Circa Enterprises

What Is Circa Enterprises's Net Debt?

As you can see below, Circa Enterprises had CA$2.41m of debt at September 2022, down from CA$4.74m a year prior. However, it does have CA$419.0k in cash offsetting this, leading to net debt of about CA$1.99m.

debt-equity-history-analysis
TSXV:CTO Debt to Equity History February 17th 2023

A Look At Circa Enterprises' Liabilities

We can see from the most recent balance sheet that Circa Enterprises had liabilities of CA$8.63m falling due within a year, and liabilities of CA$3.27m due beyond that. Offsetting this, it had CA$419.0k in cash and CA$6.21m in receivables that were due within 12 months. So its liabilities total CA$5.27m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Circa Enterprises is worth CA$15.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Circa Enterprises has net debt of just 0.71 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.0 times the interest expense over the last year. Another good sign is that Circa Enterprises has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Circa Enterprises'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.

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, Circa Enterprises actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Circa Enterprises's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Circa Enterprises seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Circa Enterprises (1 is potentially serious!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Valuation is complex, but we're helping make it simple.

Find out whether Circa Enterprises is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.