Creightons (LON:CRL) Seems To Use Debt Quite Sensibly

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.' 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. As with many other companies Creightons Plc (LON:CRL) makes use of debt. 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Creightons

What Is Creightons's Debt?

As you can see below, at the end of September 2020, Creightons had UK£2.90m of debt, up from UK£660.0k a year ago. Click the image for more detail. However, because it has a cash reserve of UK£2.75m, its net debt is less, at about UK£146.0k.

How Strong Is Creightons's Balance Sheet?

According to the last reported balance sheet, Creightons had liabilities of UK£11.6m due within 12 months, and liabilities of UK£3.61m due beyond 12 months. Offsetting this, it had UK£2.75m in cash and UK£13.1m in receivables that were due within 12 months. So it can boast UK£637.0k more liquid assets than total liabilities.

Having regard to Creightons's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the UK£35.9m company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Creightons has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

Creightons has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.025 and EBIT of 20.6 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. On top of that, Creightons grew its EBIT by 58% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Creightons's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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, Creightons reported free cash flow worth 6.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

The good news is that Creightons's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at the bigger picture, we think Creightons's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Creightons you should be aware of, and 1 of them is a bit unpleasant.

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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