David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Party City Holdco Inc. (NYSE:PRTY) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Party City Holdco’s Debt?
As you can see below, at the end of September 2019, Party City Holdco had US$2.03b of debt, up from US$2.1k a year ago. Click the image for more detail. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Party City Holdco’s Balance Sheet?
The latest balance sheet data shows that Party City Holdco had liabilities of US$970.6m due within a year, and liabilities of US$2.48b falling due after that. Offsetting these obligations, it had cash of US$34.6m as well as receivables valued at US$168.1m due within 12 months. So it has liabilities totalling US$3.25b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$269.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. At the end of the day, Party City Holdco would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Weak interest cover of 1.8 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Party City Holdco like a one-two punch to the gut. The debt burden here is substantial. Even worse, Party City Holdco saw its EBIT tank 27% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Party City Holdco can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Party City Holdco recorded free cash flow of 25% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Party City Holdco’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that Party City Holdco really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we’ve spotted 2 warning signs for Party City Holdco (of which 1 is significant!) you should know about.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.
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