Is Franchise Group (NASDAQ:FRG) A Risky Investment?

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 can see that Franchise Group, Inc. (NASDAQ:FRG) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Franchise Group

How Much Debt Does Franchise Group Carry?

As you can see below, at the end of September 2021, Franchise Group had US$1.07b of debt, up from US$627.5m a year ago. Click the image for more detail. However, it also had US$160.0m in cash, and so its net debt is US$910.2m.

A Look At Franchise Group's Liabilities

We can see from the most recent balance sheet that Franchise Group had liabilities of US$554.4m falling due within a year, and liabilities of US$1.64b due beyond that. On the other hand, it had cash of US$160.0m and US$95.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.94b.

Given this deficit is actually higher than the company's market capitalization of US$1.72b, we think shareholders really should watch Franchise Group'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Franchise Group's debt to EBITDA ratio (3.0) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for Franchise Group is that it turned last year's EBIT loss into a gain of US$240m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Franchise Group'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Franchise Group recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Franchise Group's level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Overall, we think it's fair to say that Franchise Group has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Franchise Group (of which 1 doesn't sit too well with us!) you should know about.

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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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.