FirstService (TSE:FSV) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies FirstService Corporation (TSE:FSV) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for FirstService

What Is FirstService's Net Debt?

As you can see below, at the end of March 2023, FirstService had US$822.9m of debt, up from US$668.8m a year ago. Click the image for more detail. However, it also had US$131.4m in cash, and so its net debt is US$691.5m.

A Look At FirstService's Liabilities

According to the last reported balance sheet, FirstService had liabilities of US$646.6m due within 12 months, and liabilities of US$1.12b due beyond 12 months. Offsetting this, it had US$131.4m in cash and US$706.7m in receivables that were due within 12 months. So its liabilities total US$931.9m more than the combination of its cash and short-term receivables.

Given FirstService has a market capitalization of US$6.55b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

With a debt to EBITDA ratio of 2.0, FirstService uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.5 times its interest expenses harmonizes with that theme. If FirstService can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. 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 FirstService's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, FirstService recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

We feel that FirstService's solid EBIT growth rate was really heart warming, like a mid-winter fair trade hot chocolate in a tasteful alpine chalet. And its interest cover should also leave shareholders feeling frolicsome. Looking at all the aforementioned factors together, it strikes us that FirstService can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that FirstService is showing 2 warning signs in our investment analysis , and 1 of those is concerning...

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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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.