The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Groupe Capelli (EPA:CAPLI) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Groupe Capelli's Debt?
The image below, which you can click on for greater detail, shows that at September 2020 Groupe Capelli had debt of €291.0m, up from €271.8m in one year. However, it does have €89.8m in cash offsetting this, leading to net debt of about €201.1m.
A Look At Groupe Capelli's Liabilities
Zooming in on the latest balance sheet data, we can see that Groupe Capelli had liabilities of €440.8m due within 12 months and liabilities of €107.3m due beyond that. On the other hand, it had cash of €89.8m and €266.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €192.1m.
The deficiency here weighs heavily on the €70.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Groupe Capelli 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 9.3 hit our confidence in Groupe Capelli like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On the other hand, Groupe Capelli grew its EBIT by 27% 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. 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 Groupe Capelli'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. During the last three years, Groupe Capelli burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Groupe Capelli's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Groupe Capelli to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 4 warning signs for Groupe Capelli (1 is a bit unpleasant!) that you should be aware of before investing here.
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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