Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Dark Knight, Inc. (NYSE: BKI) is in debt. But the more important question is: what risk does this debt create?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
What is Black Knight Net Debt?
As you can see below, at the end of September 2021, Black Knight had $2.50 billion in debt, up from $2.34 billion a year ago. Click on the image for more details. However, he also had $78.1 million in cash, so his net debt is $2.42 billion.
How healthy is Black Knight’s balance sheet?
According to the last published balance sheet, Black Knight had liabilities of $261.2 million due within 12 months and liabilities of $2.91 billion due beyond 12 months. In return, he had $78.1 million in cash and $217.3 million in receivables due within 12 months. Thus, its liabilities total $2.87 billion more than the combination of its cash and short-term receivables.
Black Knight has a very large market capitalization of US$11.5 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Black Knight’s debt is 4.8 times its EBITDA and its EBIT covers its interest expense 3.6 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. More concerning, Black Knight has seen its EBIT fall by 2.6% over the last twelve months. If he continues like this, paying off his debt will be like running on a treadmill – a lot of effort for little progress. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s future earnings, more than anything, that will determine Black Knight’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Fortunately for all shareholders, Black Knight has actually produced more free cash flow than EBIT over the past three years. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our point of view
According to our analysis, Black Knight’s conversion of EBIT to free cash flow should signal that it won’t have too many problems with its debt. However, our other observations were not so encouraging. In particular, the net debt to EBITDA gives us chills. When we consider all the factors mentioned above, we feel a bit cautious about Black Knight’s use of debt. While we understand that debt can improve return on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. We have identified 1 warning sign with Black Knight, and understanding them should be part of your investment process.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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