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.' 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, Cargojet Inc. (TSE:CJT) does carry debt. But the real question is whether this debt is making the company risky.
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Cargojet's Net Debt?
The image below, which you can click on for greater detail, shows that Cargojet had debt of CA$366.4m at the end of September 2020, a reduction from CA$508.1m over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Cargojet's Balance Sheet?
The latest balance sheet data shows that Cargojet had liabilities of CA$141.5m due within a year, and liabilities of CA$798.8m falling due after that. On the other hand, it had cash of CA$1.40m and CA$47.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$891.3m.
This deficit isn't so bad because Cargojet is worth CA$3.21b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Cargojet has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.3 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Cargojet's EBIT launched higher than Elon Musk, gaining a whopping 151% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cargojet'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Cargojet saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither Cargojet's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Cargojet is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Cargojet (of which 1 makes us a bit uncomfortable!) you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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