Is CLS Holdings (LON:CLI) Using Too Much Debt?

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 can see that CLS Holdings plc (LON:CLI) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for CLS Holdings

How Much Debt Does CLS Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 CLS Holdings had UK£1.05b of debt, an increase on UK£920.3m, over one year. However, it does have UK£168.7m in cash offsetting this, leading to net debt of about UK£885.1m.

A Look At CLS Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that CLS Holdings had liabilities of UK£206.6m due within 12 months and liabilities of UK£1.08b due beyond that. Offsetting this, it had UK£168.7m in cash and UK£11.3m in receivables that were due within 12 months. So its liabilities total UK£1.11b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's UK£945.2m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

CLS Holdings has a rather high debt to EBITDA ratio of 11.8 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.9 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that CLS Holdings actually let its EBIT decrease by 5.6% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CLS Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, CLS Holdings produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over CLS Holdings's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that CLS Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 4 warning signs for CLS Holdings you should be aware of, and 1 of them doesn't sit too well with us.

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.

When trading CLS Holdings or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.