Is Mainstreet Equity (TSE:MEQ) Using Too Much Debt?

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 Mainstreet Equity Corp. (TSE:MEQ) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

Check out our latest analysis for Mainstreet Equity

What Is Mainstreet Equity's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Mainstreet Equity had debt of CA$1.65b, up from CA$1.57b in one year. However, it also had CA$48.8m in cash, and so its net debt is CA$1.60b.

How Healthy Is Mainstreet Equity's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Mainstreet Equity had liabilities of CA$186.0m due within 12 months and liabilities of CA$1.79b due beyond that. Offsetting this, it had CA$48.8m in cash and CA$5.75m in receivables that were due within 12 months. So its liabilities total CA$1.92b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CA$1.90b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Mainstreet Equity has a rather high debt to EBITDA ratio of 11.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. On the other hand, Mainstreet Equity grew its EBIT by 25% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Mainstreet Equity can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Mainstreet Equity produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mainstreet Equity's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. When we consider all the factors discussed, it seems to us that Mainstreet Equity 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. We've identified 3 warning signs with Mainstreet Equity (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.