These 4 Measures Indicate That CDRL (WSE:CDL) Is Using Debt Reasonably Well

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that CDRL S.A. (WSE:CDL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 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 CDRL

What Is CDRL's Net Debt?

The image below, which you can click on for greater detail, shows that CDRL had debt of zł39.5m at the end of June 2021, a reduction from zł80.2m over a year. However, it also had zł8.32m in cash, and so its net debt is zł31.2m.

How Strong Is CDRL's Balance Sheet?

According to the last reported balance sheet, CDRL had liabilities of zł141.9m due within 12 months, and liabilities of zł50.5m due beyond 12 months. Offsetting these obligations, it had cash of zł8.32m as well as receivables valued at zł19.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł164.7m.

Given this deficit is actually higher than the company's market capitalization of zł152.1m, we think shareholders really should watch CDRL's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

While CDRL's low debt to EBITDA ratio of 0.92 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way CDRL could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 18%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since CDRL 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, CDRL actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

When it comes to the balance sheet, the standout positive for CDRL was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. In particular, level of total liabilities gives us cold feet. When we consider all the elements mentioned above, it seems to us that CDRL is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example CDRL has 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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. 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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