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.' 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. As with many other companies EVI Industries, Inc. (NYSEMKT:EVI) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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 EVI Industries's Net Debt?
You can click the graphic below for the historical numbers, but it shows that EVI Industries had US$22.7m of debt in December 2020, down from US$34.8m, one year before. However, it does have US$4.98m in cash offsetting this, leading to net debt of about US$17.7m.
A Look At EVI Industries' Liabilities
The latest balance sheet data shows that EVI Industries had liabilities of US$51.3m due within a year, and liabilities of US$30.6m falling due after that. Offsetting these obligations, it had cash of US$4.98m as well as receivables valued at US$31.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$45.2m.
Of course, EVI Industries has a market capitalization of US$448.4m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
EVI Industries has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 2.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, EVI Industries's EBIT was down 61% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since EVI Industries 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, EVI Industries actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Based on what we've seen EVI Industries is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about EVI Industries's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 3 warning signs for EVI Industries you should be aware of, and 1 of them is a bit concerning.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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What are the risks and opportunities for EVI Industries?
Shareholders have been diluted in the past year
Profit margins (1.5%) are lower than last year (3.6%)
Volatile share price over the past 3 months
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EVI Industries, Inc., through its subsidiaries, distributes, sells, rents, and leases commercial and industrial laundry and dry-cleaning equipment, and steam and hot water boilers in the United States, Canada, the Caribbean, and Latin America.
Adequate balance sheet with questionable track record.