Mainstreet Equity (TSE:MEQ) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Mainstreet Equity Corp. (TSE:MEQ) does carry debt. But is this debt a concern to shareholders?

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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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

What Is Mainstreet Equity's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Mainstreet Equity had CA$1.73b of debt, an increase on CA$1.66b, over one year. On the flip side, it has CA$125.4m in cash leading to net debt of about CA$1.60b.

How Healthy Is Mainstreet Equity's Balance Sheet?

We can see from the most recent balance sheet that Mainstreet Equity had liabilities of CA$303.5m falling due within a year, and liabilities of CA$1.76b due beyond that. On the other hand, it had cash of CA$125.4m and CA$6.07m worth of receivables due within a year. So its liabilities total CA$1.93b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CA$1.77b, we think shareholders really should watch Mainstreet Equity's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

View our latest analysis for Mainstreet Equity

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Mainstreet Equity has a rather high debt to EBITDA ratio of 10.8 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 a lighter note, we note that Mainstreet Equity grew its EBIT by 25% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Mainstreet Equity'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Mainstreet Equity recorded free cash flow worth 63% 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

Mainstreet Equity's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Taking the abovementioned factors together we do think Mainstreet Equity's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Mainstreet Equity (including 2 which make us uncomfortable) .

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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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.