Centrale d'Achat Française pour l'Outre-Mer Société Anonyme (EPA:CAFO) Seems To Use Debt Quite Sensibly

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. As with many other companies Centrale d'Achat Française pour l'Outre-Mer Société Anonyme (EPA:CAFO) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Centrale d'Achat Française pour l'Outre-Mer Société Anonyme

How Much Debt Does Centrale d'Achat Française pour l'Outre-Mer Société Anonyme Carry?

You can click the graphic below for the historical numbers, but it shows that Centrale d'Achat Française pour l'Outre-Mer Société Anonyme had €61.4m of debt in September 2020, down from €66.1m, one year before. However, it does have €35.0m in cash offsetting this, leading to net debt of about €26.5m.

How Healthy Is Centrale d'Achat Française pour l'Outre-Mer Société Anonyme's Balance Sheet?

The latest balance sheet data shows that Centrale d'Achat Française pour l'Outre-Mer Société Anonyme had liabilities of €201.2m due within a year, and liabilities of €152.5m falling due after that. Offsetting this, it had €35.0m in cash and €34.0m in receivables that were due within 12 months. So it has liabilities totalling €284.7m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the €90.7m 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'd watch its balance sheet closely, without a doubt. After all, Centrale d'Achat Française pour l'Outre-Mer Société Anonyme would likely require a major re-capitalisation if it had to pay its creditors today.

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).

While Centrale d'Achat Française pour l'Outre-Mer Société Anonyme's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Centrale d'Achat Française pour l'Outre-Mer Société Anonyme grew its EBIT by 43% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Centrale d'Achat Française pour l'Outre-Mer Société Anonyme's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Centrale d'Achat Française pour l'Outre-Mer Société Anonyme recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Based on what we've seen Centrale d'Achat Française pour l'Outre-Mer Société Anonyme is not finding it easy, given its level of total liabilities, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Centrale d'Achat Française pour l'Outre-Mer Société Anonyme's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Centrale d'Achat Française pour l'Outre-Mer Société Anonyme that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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