Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that CEPS PLC (LON:CEPS) does use debt in its business. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is CEPS's Net Debt?
As you can see below, at the end of December 2020, CEPS had UK£10.3m of debt, up from UK£7.23m a year ago. Click the image for more detail. However, it does have UK£2.33m in cash offsetting this, leading to net debt of about UK£7.94m.
How Strong Is CEPS' Balance Sheet?
We can see from the most recent balance sheet that CEPS had liabilities of UK£8.03m falling due within a year, and liabilities of UK£7.35m due beyond that. Offsetting this, it had UK£2.33m in cash and UK£1.88m in receivables that were due within 12 months. So its liabilities total UK£11.2m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the UK£6.21m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, CEPS 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 0.31 times and a disturbingly high net debt to EBITDA ratio of 9.6 hit our confidence in CEPS like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for CEPS is that it turned last year's EBIT loss into a gain of UK£229k, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since CEPS will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, CEPS actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
To be frank both CEPS's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider CEPS 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. 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. To that end, you should be aware of the 2 warning signs we've spotted with CEPS .
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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