Stock Analysis

These 4 Measures Indicate That Zedcor (CVE:ZDC) Is Using Debt Extensively

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TSXV:ZDC
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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 Zedcor Inc. (CVE:ZDC) does use debt in its business. But is this debt a concern to shareholders?

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. 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, 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.

Check out our latest analysis for Zedcor

What Is Zedcor's Debt?

As you can see below, Zedcor had CA$7.92m of debt at June 2021, down from CA$20.5m a year prior. Net debt is about the same, since the it doesn't have much cash.

debt-equity-history-analysis
TSXV:ZDC Debt to Equity History October 19th 2021

How Strong Is Zedcor's Balance Sheet?

We can see from the most recent balance sheet that Zedcor had liabilities of CA$5.84m falling due within a year, and liabilities of CA$10.6m due beyond that. On the other hand, it had cash of CA$1.0k and CA$3.77m worth of receivables due within a year. So its liabilities total CA$12.7m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CA$18.9m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zedcor shareholders face the double whammy of a high net debt to EBITDA ratio (16.2), and fairly weak interest coverage, since EBIT is just 0.10 times the interest expense. The debt burden here is substantial. However, the silver lining was that Zedcor achieved a positive EBIT of CA$375k in the last twelve months, an improvement on the prior year's loss. 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 Zedcor's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Zedcor 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.

Our View

On the face of it, Zedcor's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Zedcor's balance sheet is really quite a risk to the business. 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. We've identified 3 warning signs with Zedcor (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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