We Think C.S. Lumber (TYO:7808) Is Taking Some Risk With Its Debt

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.' 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 C.S. Lumber Co., Inc (TYO:7808) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View 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¥5.17b at the end of August 2020, a reduction from JP¥5.76b over a year. However, it does have JP¥1.66b in cash offsetting this, leading to net debt of about JP¥3.51b.

How Healthy Is C.S. Lumber's Balance Sheet?

The latest balance sheet data shows that C.S. Lumber had liabilities of JP¥5.05b due within a year, and liabilities of JP¥5.22b falling due after that. Offsetting this, it had JP¥1.66b in cash and JP¥2.04b in receivables that were due within 12 months. So its liabilities total JP¥6.57b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the JP¥2.75b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, C.S. Lumber would probably need a major re-capitalization if its creditors were to demand repayment.

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).

C.S. Lumber's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its commanding EBIT of 11.6 times its interest expense, implies the debt load is as light as a peacock feather. C.S. Lumber grew its EBIT by 9.2% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, C.S. Lumber burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both C.S. Lumber's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that C.S. Lumber's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Take risks, for example - C.S. Lumber has 3 warning signs we think you should be aware of.

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.

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