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. As with many other companies Chorus Limited (NZSE:CNU) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Chorus's Debt?
The chart below, which you can click on for greater detail, shows that Chorus had NZ$3.02b in debt in June 2021; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
A Look At Chorus' Liabilities
We can see from the most recent balance sheet that Chorus had liabilities of NZ$461.0m falling due within a year, and liabilities of NZ$4.45b due beyond that. On the other hand, it had cash of NZ$53.0m and NZ$145.0m worth of receivables due within a year. So its liabilities total NZ$4.71b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the NZ$2.97b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Chorus would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Chorus like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Another concern for investors might be that Chorus's EBIT fell 11% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chorus's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Chorus burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Chorus's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Chorus really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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 instance, we've identified 2 warning signs for Chorus that you should be aware of.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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