Covalon Technologies (CVE:COV) Is Making Moderate Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Covalon Technologies Ltd. (CVE:COV) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Covalon Technologies

What Is Covalon Technologies's Net Debt?

As you can see below, Covalon Technologies had CA$18.2m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had CA$4.20m in cash, and so its net debt is CA$14.0m.

A Look At Covalon Technologies's Liabilities

According to the last reported balance sheet, Covalon Technologies had liabilities of CA$23.7m due within 12 months, and liabilities of CA$3.20m due beyond 12 months. Offsetting this, it had CA$4.20m in cash and CA$3.53m in receivables that were due within 12 months. So it has liabilities totalling CA$19.1m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CA$28.9m, so it does suggest shareholders should keep an eye on Covalon Technologies's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Covalon Technologies's earnings that will influence how the balance sheet holds up in the future. 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.

In the last year Covalon Technologies had a loss before interest and tax, and actually shrunk its revenue by 22%, to CA$26m. That makes us nervous, to say the least.

Caveat Emptor

Not only did Covalon Technologies's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping CA$6.9m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through CA$3.2m of cash over the last year. So suffice it to say we consider the stock very risky. 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. Case in point: We've spotted 2 warning signs for Covalon Technologies you should be aware of, and 1 of them can't be ignored.

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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