Is Kathmandu Holdings (NZSE:KMD) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Kathmandu Holdings Limited (NZSE:KMD) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

Check out our latest analysis for Kathmandu Holdings

What Is Kathmandu Holdings's Debt?

As you can see below, at the end of July 2020, Kathmandu Holdings had NZ$241.3m of debt, up from NZ$25.6m a year ago. Click the image for more detail. However, because it has a cash reserve of NZ$231.9m, its net debt is less, at about NZ$9.44m.

How Strong Is Kathmandu Holdings' Balance Sheet?

The latest balance sheet data shows that Kathmandu Holdings had liabilities of NZ$236.8m due within a year, and liabilities of NZ$557.5m falling due after that. Offsetting this, it had NZ$231.9m in cash and NZ$77.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$484.9m.

Kathmandu Holdings has a market capitalization of NZ$957.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Carrying virtually no net debt, Kathmandu Holdings has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Kathmandu Holdings has a very low debt to EBITDA ratio of 0.17 so it is strange to see weak interest coverage, with last year's EBIT being only 2.3 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Importantly, Kathmandu Holdings's EBIT fell a jaw-dropping 63% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Kathmandu Holdings'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kathmandu Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While Kathmandu Holdings's EBIT growth rate has us nervous. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. We think that Kathmandu Holdings's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 3 warning signs for Kathmandu Holdings (1 is a bit concerning!) that you should be aware of before investing here.

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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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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