Does City Pub Group (LON:CPC) Have A Healthy Balance Sheet?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that The City Pub Group plc (LON:CPC) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for City Pub Group

What Is City Pub Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 City Pub Group had UK£9.74m of debt, an increase on UK£5.63m, over one year. However, because it has a cash reserve of UK£5.81m, its net debt is less, at about UK£3.93m.

How Healthy Is City Pub Group's Balance Sheet?

According to the last reported balance sheet, City Pub Group had liabilities of UK£18.9m due within 12 months, and liabilities of UK£28.4m due beyond 12 months. On the other hand, it had cash of UK£5.81m and UK£4.08m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£37.4m.

While this might seem like a lot, it is not so bad since City Pub Group has a market capitalization of UK£101.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While City Pub Group's low debt to EBITDA ratio of 0.57 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. The bad news is that City Pub Group saw its EBIT decline by 14% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 City Pub Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, City Pub Group generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On our analysis City Pub Group's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about City Pub Group'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that City Pub Group is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.