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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.’ 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 note that K-Bro Linen Inc. (TSE:KBL) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
Check out our latest analysis for K-Bro Linen
How Much Debt Does K-Bro Linen Carry?
As you can see below, at the end of March 2019, K-Bro Linen had CA$67.4m of debt, up from CA$56.4m a year ago. Click the image for more detail. On the flip side, it has CA$2.55m in cash leading to net debt of about CA$64.9m.
A Look At K-Bro Linen’s Liabilities
The latest balance sheet data shows that K-Bro Linen had liabilities of CA$42.8m due within a year, and liabilities of CA$123.0m falling due after that. On the other hand, it had cash of CA$2.55m and CA$33.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$129.9m.
This deficit isn’t so bad because K-Bro Linen is worth CA$424.4m, 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. Because it carries more debt than cash, we think it’s worth watching K-Bro Linen’s balance sheet over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
K-Bro Linen has net debt worth 2.01 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.15 times the interest expense. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Unfortunately, K-Bro Linen’s EBIT flopped 19% over the last four quarters. 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 ultimately the future profitability of the business will decide if K-Bro Linen 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, K-Bro Linen 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
To be frank both K-Bro Linen’s EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability handle its debt, based on its EBITDA, isn’t such a worry. We’re quite clear that we consider K-Bro Linen to be really rather risky, as a result of its debt. 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. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.