Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Jewett-Cameron Trading Company Ltd. (NASDAQ:JCTC.F) uses debt in its business. But the more important question is: what risk does this debt create?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
How much debt does Jewett-Cameron Trading have?
As you can see below, at the end of November 2021, Jewett-Cameron Trading had $5.00 million in debt, up from $680.7,000 a year ago. Click on the image for more details. However, he also had $1.24 million in cash, so his net debt is $3.76 million.
A look at the responsibilities of Jewett-Cameron Trading
We can see from the most recent balance sheet that Jewett-Cameron Trading had liabilities of US$8.68 million due in one year, and liabilities of US$125.8,000 due beyond. In return, he had $1.24 million in cash and $5.81 million in receivables due within 12 months. Thus, its liabilities total $1.76 million more than the combination of its cash and short-term receivables.
Of course, Jewett-Cameron Trading has a market cap of US$27.0 million, so those liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Jewett-Cameron Trading has a low net debt to EBITDA ratio of just 1.3. And its EBIT covers its interest charges 114 times. So we’re pretty relaxed about his super conservative use of debt. Fortunately, Jewett-Cameron Trading’s burden is not too heavy, as its EBIT fell by 41% over the last year. When a company sees its profit reservoir, it can sometimes find its relationship with its lenders soured. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; since Jewett-Cameron Trading will need revenue to repay this debt. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cash, not book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Jewett-Cameron Trading has experienced substantial negative free cash flow, in total. While investors no doubt expect a reversal of this situation in due course, this clearly means that its use of debt is more risky.
Our point of view
Jewett-Cameron Trading’s EBIT growth rate and EBIT to free cash flow conversion are certainly weighing on it, in our view. But the good news is that it seems to be able to easily cover its interest costs with its EBIT. When we consider all the factors discussed, it seems to us that Jewett-Cameron Trading is taking risks with its use of debt. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, Jewett-Cameron Trading has 4 warning signs (and 1 that can’t be ignored) that we think you should know about.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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