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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. We note that Crown Crafts, Inc. (NASDAQ:CRWS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Crown Crafts Carry?
You can click the graphic below for the historical numbers, but it shows that Crown Crafts had US$4.49m of debt in March 2019, down from US$9.46m, one year before On the flip side, it has US$143.0k in cash leading to net debt of about US$4.34m.
How Healthy Is Crown Crafts’s Balance Sheet?
According to the last reported balance sheet, Crown Crafts had liabilities of US$7.71m due within 12 months, and liabilities of US$5.68m due beyond 12 months. On the other hand, it had cash of US$143.0k and US$17.8m worth of receivables due within a year. So it can boast US$4.52m more liquid assets than total liabilities.
This short term liquidity is a sign that Crown Crafts could probably pay off its debt with ease, as its balance sheet is far from stretched. Since Crown Crafts does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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).
Crown Crafts has a low net debt to EBITDA ratio of only 0.50. And its EBIT covers its interest expense a whopping 22.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Crown Crafts saw its EBIT decline by 5.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Crown Crafts’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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Crown Crafts recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
The good news is that Crown Crafts’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Zooming out, Crown Crafts seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Crown Crafts insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.