Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that FRP Holdings, Inc. (NASDAQ:FRPH) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is FRP Holdings's Debt?
The chart below, which you can click on for greater detail, shows that FRP Holdings had US$89.0m in debt in September 2020; about the same as the year before. However, it does have US$46.3m in cash offsetting this, leading to net debt of about US$42.7m.
A Look At FRP Holdings' Liabilities
Zooming in on the latest balance sheet data, we can see that FRP Holdings had liabilities of US$3.22m due within 12 months and liabilities of US$145.6m due beyond that. Offsetting these obligations, it had cash of US$46.3m as well as receivables valued at US$923.0k due within 12 months. So its liabilities total US$101.6m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since FRP Holdings has a market capitalization of US$423.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
As it happens FRP Holdings has a fairly concerning net debt to EBITDA ratio of 6.9 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, FRP Holdings's EBIT fell a jaw-dropping 98% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since FRP Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, FRP Holdings 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.
We weren't impressed with FRP Holdings's net debt to EBITDA, and its EBIT growth rate made us cautious. But its interest cover was significantly redeeming. When we consider all the factors mentioned above, we do feel a bit cautious about FRP Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 3 warning signs for FRP Holdings you should be aware of, and 1 of them is a bit concerning.
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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