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.' 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. We can see that Restaurant Brands New Zealand Limited (NZSE:RBD) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Restaurant Brands New Zealand's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Restaurant Brands New Zealand had NZ$239.1m of debt, an increase on NZ$156.5m, over one year. However, it also had NZ$35.7m in cash, and so its net debt is NZ$203.4m.
A Look At Restaurant Brands New Zealand's Liabilities
We can see from the most recent balance sheet that Restaurant Brands New Zealand had liabilities of NZ$144.3m falling due within a year, and liabilities of NZ$798.2m due beyond that. Offsetting these obligations, it had cash of NZ$35.7m as well as receivables valued at NZ$11.4m due within 12 months. So it has liabilities totalling NZ$895.5m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Restaurant Brands New Zealand has a market capitalization of NZ$1.67b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Restaurant Brands New Zealand has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 1.9. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Restaurant Brands New Zealand's EBIT was down 27% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Restaurant Brands New Zealand's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Restaurant Brands New Zealand produced sturdy free cash flow equating to 59% 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.
On the face of it, Restaurant Brands New Zealand's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Restaurant Brands New Zealand stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Restaurant Brands New Zealand (at least 1 which is potentially serious) , and understanding them should be part of your investment process.
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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Restaurant Brands New Zealand
Restaurant Brands New Zealand Limited, together with its subsidiaries, operates quick service and takeaway restaurants in New Zealand, Australia, California, Hawaii, Saipan, and Guam.
Reasonable growth potential and fair value.