Is C.S. Lumber (TYO:7808) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that C.S. Lumber Co., Inc (TYO:7808) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for C.S. Lumber

How Much Debt Does C.S. Lumber Carry?

The image below, which you can click on for greater detail, shows that C.S. Lumber had debt of JP¥4.98b at the end of November 2020, a reduction from JP¥5.99b over a year. On the flip side, it has JP¥2.00b in cash leading to net debt of about JP¥2.98b.

A Look At C.S. Lumber's Liabilities

The latest balance sheet data shows that C.S. Lumber had liabilities of JP¥5.59b due within a year, and liabilities of JP¥5.10b falling due after that. Offsetting this, it had JP¥2.00b in cash and JP¥2.47b in receivables that were due within 12 months. So it has liabilities totalling JP¥6.22b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥3.30b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, C.S. Lumber 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). 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).

We'd say that C.S. Lumber's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its strong interest cover of 13.2 times, makes us even more comfortable. One way C.S. Lumber could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since C.S. Lumber 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 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, C.S. Lumber recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, C.S. Lumber's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider C.S. Lumber 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for C.S. Lumber you should know about.

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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This article by Simply Wall St is general in nature. 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.
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