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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. As with many other companies. Canfor Pulp Products Inc. (TSE:CFX) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Canfor Pulp Products’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Canfor Pulp Products had CA$23.0m of debt, an increase on none, over one year. However, it also had CA$6.90m in cash, and so its net debt is CA$16.1m.
How Healthy Is Canfor Pulp Products’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Canfor Pulp Products had liabilities of CA$180.3m due within 12 months and liabilities of CA$161.1m due beyond that. On the other hand, it had cash of CA$6.90m and CA$134.2m worth of receivables due within a year. So it has liabilities totalling CA$200.3m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Canfor Pulp Products has a market capitalization of CA$700.8m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Because it carries more debt than cash, we think it’s worth watching Canfor Pulp Products’s balance sheet over time.
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 debt at a measly 0.062 times EBITDA and EBIT covering interest a whopping 104 times, it’s clear that Canfor Pulp Products is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. On the other hand, Canfor Pulp Products’s EBIT dived 12%, over the last year. 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 ultimately the future profitability of the business will decide if Canfor Pulp Products 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Canfor Pulp Products produced sturdy free cash flow equating to 54% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
When it comes to the balance sheet, the standout positive for Canfor Pulp Products was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren’t so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Canfor Pulp Products’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. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Canfor Pulp Products insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.