Is Rocky Mountain Chocolate Factory (NASDAQ:RMCF) Using Debt Sensibly?

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.' 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 Rocky Mountain Chocolate Factory, Inc. (NASDAQ:RMCF) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. 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 Rocky Mountain Chocolate Factory

What Is Rocky Mountain Chocolate Factory's Debt?

You can click the graphic below for the historical numbers, but it shows that as of May 2020 Rocky Mountain Chocolate Factory had US$4.99m of debt, an increase on US$829.9k, over one year. But on the other hand it also has US$7.44m in cash, leading to a US$2.45m net cash position.

How Healthy Is Rocky Mountain Chocolate Factory's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rocky Mountain Chocolate Factory had liabilities of US$9.68m due within 12 months and liabilities of US$3.60m due beyond that. Offsetting this, it had US$7.44m in cash and US$2.85m in receivables that were due within 12 months. So its liabilities total US$2.99m more than the combination of its cash and short-term receivables.

Since publicly traded Rocky Mountain Chocolate Factory shares are worth a total of US$16.4m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Rocky Mountain Chocolate Factory also has more cash than debt, so we're pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Rocky Mountain Chocolate Factory's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Rocky Mountain Chocolate Factory made a loss at the EBIT level, and saw its revenue drop to US$26m, which is a fall of 24%. That makes us nervous, to say the least.

So How Risky Is Rocky Mountain Chocolate Factory?

Although Rocky Mountain Chocolate Factory had an earnings before interest and tax (EBIT) loss over the last twelve months, it generated positive free cash flow of US$130k. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. Until we see some positive EBIT, we're a bit cautious of the stock, not least because of the rather modest revenue growth. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Rocky Mountain Chocolate Factory (including 1 which is is a bit unpleasant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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