We Think Freehold Royalties (TSE:FRU) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Freehold Royalties Ltd. (TSE:FRU) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Freehold Royalties

What Is Freehold Royalties's Debt?

The image below, which you can click on for greater detail, shows that Freehold Royalties had debt of CA$141.2m at the end of September 2023, a reduction from CA$196.9m over a year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Freehold Royalties' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Freehold Royalties had liabilities of CA$24.3m due within 12 months and liabilities of CA$184.2m due beyond that. Offsetting this, it had CA$702.0k in cash and CA$58.2m in receivables that were due within 12 months. So it has liabilities totalling CA$149.6m more than its cash and near-term receivables, combined.

Since publicly traded Freehold Royalties shares are worth a total of CA$2.11b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Freehold Royalties's net debt is only 0.47 times its EBITDA. And its EBIT easily covers its interest expense, being 18.7 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Freehold Royalties has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Freehold Royalties'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Freehold Royalties created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Freehold Royalties's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. Looking at all this data makes us feel a little cautious about Freehold Royalties'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. Case in point: We've spotted 2 warning signs for Freehold Royalties you should be aware of, and 1 of them is a bit unpleasant.

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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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.