We Think Chemtrade Logistics Income Fund (TSE:CHE.UN) Is Taking Some Risk With Its Debt

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 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. We note that Chemtrade Logistics Income Fund (TSE:CHE.UN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Chemtrade Logistics Income Fund

What Is Chemtrade Logistics Income Fund's Debt?

As you can see below, Chemtrade Logistics Income Fund had CA$876.2m of debt at September 2022, down from CA$1.26b a year prior. However, because it has a cash reserve of CA$36.9m, its net debt is less, at about CA$839.3m.

How Strong Is Chemtrade Logistics Income Fund's Balance Sheet?

We can see from the most recent balance sheet that Chemtrade Logistics Income Fund had liabilities of CA$403.0m falling due within a year, and liabilities of CA$1.15b due beyond that. On the other hand, it had cash of CA$36.9m and CA$154.5m worth of receivables due within a year. So its liabilities total CA$1.36b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CA$1.07b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Chemtrade Logistics Income Fund's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We also note that Chemtrade Logistics Income Fund improved its EBIT from a last year's loss to a positive CA$186m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chemtrade Logistics Income Fund'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Chemtrade Logistics Income Fund actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Chemtrade Logistics Income Fund's level of total liabilities and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Chemtrade Logistics Income Fund is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example Chemtrade Logistics Income Fund has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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.