Yahoo Finance Freehold Royalties (TSE:FRU) Seems To Use Debt Quite Sensibly
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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Freehold Royalties Ltd. (TSE:FRU) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Freehold Royalties
How Much Debt Does Freehold Royalties Carry?
The image below, which you can click on for greater detail, shows that Freehold Royalties had debt of CA$90.0m at the end of March 2019, a reduction from CA$98.0m over a year. Net debt is about the same, since the it doesn't have much cash.
How Strong Is Freehold Royalties's Balance Sheet?
According to the last reported balance sheet, Freehold Royalties had liabilities of CA$13.9m due within 12 months, and liabilities of CA$100.0m due beyond 12 months. Offsetting this, it had CA$931.0k in cash and CA$23.7m in receivables that were due within 12 months. So it has liabilities totalling CA$89.3m more than its cash and near-term receivables, combined.
Since publicly traded Freehold Royalties shares are worth a total of CA$934.6m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). 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).
Looking at its net debt to EBITDA of 0.73 and interest cover of 5.6 times, it seems to us that Freehold Royalties is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Freehold Royalties's EBIT launched higher than Elon Musk, gaining a whopping 189% on last year. 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 Freehold Royalties can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Freehold Royalties recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Happily, Freehold Royalties's impressive EBIT growth rate implies it has the upper hand on its debt. And its conversion of EBIT to free cash flow is good too. Zooming out, Freehold Royalties seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We'd be motivated to research the stock further if we found out that Freehold Royalties insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.
