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

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that Mainstreet Equity Corp. (TSE:MEQ) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Mainstreet Equity

What Is Mainstreet Equity's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Mainstreet Equity had CA$1.44b of debt, an increase on CA$1.30b, over one year. On the flip side, it has CA$43.5m in cash leading to net debt of about CA$1.40b.

How Strong Is Mainstreet Equity's Balance Sheet?

According to the last reported balance sheet, Mainstreet Equity had liabilities of CA$60.9m due within 12 months, and liabilities of CA$1.62b due beyond 12 months. On the other hand, it had cash of CA$43.5m and CA$5.65m worth of receivables due within a year. So its liabilities total CA$1.63b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CA$1.05b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Mainstreet Equity would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 15.1 hit our confidence in Mainstreet Equity like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a slightly more positive note, Mainstreet Equity grew its EBIT at 11% over the last year, further increasing its ability to manage debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Mainstreet Equity recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Mainstreet Equity's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Mainstreet Equity's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 4 warning signs for Mainstreet Equity (2 are significant!) that you should be aware of before investing here.

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.