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.' 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. Importantly, Skyline Investments Inc. (TLV:SKLN) does carry 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Skyline Investments's Debt?
You can click the graphic below for the historical numbers, but it shows that Skyline Investments had CA$219.4m of debt in December 2021, down from CA$294.7m, one year before. On the flip side, it has CA$61.5m in cash leading to net debt of about CA$157.9m.
How Strong Is Skyline Investments' Balance Sheet?
The latest balance sheet data shows that Skyline Investments had liabilities of CA$199.6m due within a year, and liabilities of CA$83.0m falling due after that. On the other hand, it had cash of CA$61.5m and CA$12.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$208.5m.
When you consider that this deficiency exceeds the company's CA$177.3m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Skyline Investments shareholders face the double whammy of a high net debt to EBITDA ratio (6.6), and fairly weak interest coverage, since EBIT is just 0.20 times the interest expense. The debt burden here is substantial. One redeeming factor for Skyline Investments is that it turned last year's EBIT loss into a gain of CA$3.4m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Skyline Investments'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.
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. Over the last year, Skyline Investments actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
To be frank both Skyline Investments's net debt to EBITDA and its track record of covering its interest expense with its EBIT 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. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Skyline Investments stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example Skyline Investments has 3 warning signs (and 2 which make us uncomfortable) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.