Is Kaap Agri (JSE:KAL) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Kaap Agri Limited (JSE:KAL) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

View our latest analysis for Kaap Agri

How Much Debt Does Kaap Agri Carry?

You can click the graphic below for the historical numbers, but it shows that Kaap Agri had R1.25b of debt in September 2020, down from R1.31b, one year before. However, because it has a cash reserve of R34.8m, its net debt is less, at about R1.21b.

How Healthy Is Kaap Agri's Balance Sheet?

According to the last reported balance sheet, Kaap Agri had liabilities of R2.22b due within 12 months, and liabilities of R925.8m due beyond 12 months. Offsetting this, it had R34.8m in cash and R1.78b in receivables that were due within 12 months. So its liabilities total R1.33b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R2.20b, so it does suggest shareholders should keep an eye on Kaap Agri's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Kaap Agri's net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. We saw Kaap Agri grow its EBIT by 9.9% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is Kaap Agri'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Kaap Agri produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On our analysis Kaap Agri's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. Considering this range of data points, we think Kaap Agri is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For instance, we've identified 2 warning signs for Kaap Agri that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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