Is Covalon Technologies (CVE:COV) Using Too Much 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.' 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 Covalon Technologies Ltd. (CVE:COV) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Covalon Technologies

How Much Debt Does Covalon Technologies Carry?

The chart below, which you can click on for greater detail, shows that Covalon Technologies had CA$17.0m in debt in December 2020; about the same as the year before. On the flip side, it has CA$2.53m in cash leading to net debt of about CA$14.4m.

How Strong Is Covalon Technologies' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Covalon Technologies had liabilities of CA$21.4m due within 12 months and liabilities of CA$2.71m due beyond that. Offsetting these obligations, it had cash of CA$2.53m as well as receivables valued at CA$3.47m due within 12 months. So its liabilities total CA$18.1m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Covalon Technologies has a market capitalization of CA$37.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Covalon Technologies 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.

In the last year Covalon Technologies had a loss before interest and tax, and actually shrunk its revenue by 31%, to CA$24m. 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). Indeed, it lost a very considerable CA$4.9m at the EBIT level. 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. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of CA$6.1m into a profit. So we do think this stock is quite 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. We've identified 2 warning signs with Covalon Technologies (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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