We Think Rocky Mountain Liquor (CVE:RUM) Is Taking Some Risk With Its Debt

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. Importantly, Rocky Mountain Liquor Inc. (CVE:RUM) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

See our latest analysis for Rocky Mountain Liquor

What Is Rocky Mountain Liquor's Debt?

As you can see below, Rocky Mountain Liquor had CA$6.20m of debt at September 2020, down from CA$8.52m a year prior. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Rocky Mountain Liquor's Balance Sheet?

We can see from the most recent balance sheet that Rocky Mountain Liquor had liabilities of CA$8.24m falling due within a year, and liabilities of CA$10.6m due beyond that. On the other hand, it had cash of CA$85.6k and CA$181.4k worth of receivables due within a year. So it has liabilities totalling CA$18.5m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CA$5.70m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Rocky Mountain Liquor would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Rocky Mountain Liquor has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Notably, Rocky Mountain Liquor's EBIT launched higher than Elon Musk, gaining a whopping 181% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rocky Mountain Liquor will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Happily for any shareholders, Rocky Mountain Liquor actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about Rocky Mountain Liquor's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Rocky Mountain Liquor's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 4 warning signs for Rocky Mountain Liquor (2 shouldn't be ignored) you should be aware of.

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.

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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. 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.
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