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 can see that Pets at Home Group Plc (LON:PETS) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is at Home Group's Net Debt?
The image below, which you can click on for greater detail, shows that at Home Group had debt of UK£178.9m at the end of March 2019, a reduction from UK£194.6m over a year. However, because it has a cash reserve of UK£60.5m, its net debt is less, at about UK£118.4m.
How Strong Is at Home Group's Balance Sheet?
According to the last reported balance sheet, at Home Group had liabilities of UK£218.8m due within 12 months, and liabilities of UK£220.6m due beyond 12 months. Offsetting this, it had UK£60.5m in cash and UK£56.3m in receivables that were due within 12 months. So it has liabilities totalling UK£322.5m more than its cash and near-term receivables, combined.
This deficit isn't so bad because at Home Group is worth UK£1.14b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
at Home Group has a low net debt to EBITDA ratio of only 1.5. And its EBIT covers its interest expense a whopping 14.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Shareholders should be aware that at Home Group's EBIT was down 38% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if at Home Group 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, at Home Group recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
at Home Group's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its interest cover. Considering this range of data points, we think at Home Group is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that at Home Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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