Is Foley Wines (NZSE:FWL) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Foley Wines Limited (NZSE:FWL) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Foley Wines

What Is Foley Wines's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Foley Wines had NZ$48.5m of debt in December 2020, down from NZ$51.3m, one year before. However, it also had NZ$2.40m in cash, and so its net debt is NZ$46.1m.

How Healthy Is Foley Wines' Balance Sheet?

According to the last reported balance sheet, Foley Wines had liabilities of NZ$18.1m due within 12 months, and liabilities of NZ$62.4m due beyond 12 months. Offsetting this, it had NZ$2.40m in cash and NZ$8.28m in receivables that were due within 12 months. So its liabilities total NZ$69.9m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of NZ$113.1m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Foley Wines has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 6.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Foley Wines could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is Foley Wines'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Foley Wines recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Foley Wines's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But it seems to be able to grow its EBIT without much trouble. Looking at all the angles mentioned above, it does seem to us that Foley Wines is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 1 warning sign with Foley Wines , and understanding them should be part of your investment process.

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.

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