Here's Why Colabor Group (TSE:GCL) Can Manage Its Debt Responsibly

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 note that Colabor Group Inc. (TSE:GCL) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Colabor Group

How Much Debt Does Colabor Group Carry?

As you can see below, Colabor Group had CA$50.0m of debt at December 2021, down from CA$61.7m a year prior. However, because it has a cash reserve of CA$2.01m, its net debt is less, at about CA$48.0m.

How Healthy Is Colabor Group's Balance Sheet?

The latest balance sheet data shows that Colabor Group had liabilities of CA$54.7m due within a year, and liabilities of CA$77.1m falling due after that. On the other hand, it had cash of CA$2.01m and CA$45.7m worth of receivables due within a year. So it has liabilities totalling CA$84.1m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CA$80.5m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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 Colabor Group's debt to EBITDA ratio (3.4) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. On the other hand, Colabor Group grew its EBIT by 28% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Colabor Group 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Colabor Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Colabor Group's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Colabor Group's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Colabor Group (at least 1 which is significant) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.