Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Card Factory plc (LON:CARD) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Card Factory's Debt?
You can click the graphic below for the historical numbers, but it shows that Card Factory had UK£144.0m of debt in January 2019, down from UK£164.5m, one year before. However, because it has a cash reserve of UK£3.80m, its net debt is less, at about UK£140.2m.
How Strong Is Card Factory's Balance Sheet?
We can see from the most recent balance sheet that Card Factory had liabilities of UK£72.3m falling due within a year, and liabilities of UK£154.6m due beyond that. Offsetting this, it had UK£3.80m in cash and UK£700.0k in receivables that were due within 12 months. So its liabilities total UK£222.4m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Card Factory has a market capitalization of UK£532.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We'd say that Card Factory's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its commanding EBIT of 21.2 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Card Factory saw its EBIT slide 5.9% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Card Factory'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Card Factory generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Card Factory's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Card Factory can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Card Factory insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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