David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Cresco Labs Inc. (CSE:CL) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Cresco Labs's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Cresco Labs had US$118.9m of debt, an increase on none, over one year. However, it also had US$57.7m in cash, and so its net debt is US$61.2m.
A Look At Cresco Labs's Liabilities
According to the last reported balance sheet, Cresco Labs had liabilities of US$243.7m due within 12 months, and liabilities of US$221.3m due beyond 12 months. On the other hand, it had cash of US$57.7m and US$30.2m worth of receivables due within a year. So it has liabilities totalling US$377.1m more than its cash and near-term receivables, combined.
Given Cresco Labs has a market capitalization of US$3.30b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cresco Labs has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 0.81 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, Cresco Labs made a loss at the EBIT level, last year, but improved that to positive EBIT of US$27m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cresco Labs'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Cresco Labs saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
While Cresco Labs's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its net debt to EBITDA gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Cresco Labs 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Cresco Labs you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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