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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Brampton Brick Limited (TSE:BBL.A) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. 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.
How Much Debt Does Brampton Brick Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Brampton Brick had CA$39.0m of debt, an increase on CA$36.1m, over one year. However, because it has a cash reserve of CA$9.36m, its net debt is less, at about CA$29.7m.
How Strong Is Brampton Brick’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Brampton Brick had liabilities of CA$21.5m due within 12 months and liabilities of CA$58.1m due beyond that. Offsetting this, it had CA$9.36m in cash and CA$19.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$50.5m.
This deficit is considerable relative to its market capitalization of CA$66.3m, so it does suggest shareholders should keep an eye on Brampton Brick’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Either way, since Brampton Brick does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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.
With net debt sitting at just 1.29 times EBITDA, Brampton Brick is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.23 times the interest expense over the last year. The modesty of its debt load may become crucial for Brampton Brick if management cannot prevent a repeat of the 28% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Brampton Brick 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Brampton Brick produced sturdy free cash flow equating to 71% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Brampton Brick’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. When we consider all the factors discussed, it seems to us that Brampton Brick is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Brampton Brick’s earnings per share history for free.
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.
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 email@example.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.