Here's Why Empire (TSE:EMP.A) Can Manage Its Debt Responsibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Empire Company Limited (TSE:EMP.A) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Empire

What Is Empire's Debt?

As you can see below, Empire had CA$1.17b of debt at January 2021, down from CA$1.69b a year prior. However, it also had CA$784.3m in cash, and so its net debt is CA$387.0m.

A Look At Empire's Liabilities

Zooming in on the latest balance sheet data, we can see that Empire had liabilities of CA$3.40b due within 12 months and liabilities of CA$7.17b due beyond that. Offsetting this, it had CA$784.3m in cash and CA$644.4m in receivables that were due within 12 months. So it has liabilities totalling CA$9.14b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CA$11.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

While Empire's low debt to EBITDA ratio of 0.22 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Empire grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Empire's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, Empire 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

The good news is that Empire's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Empire takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Empire that you should be aware of.

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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