Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. 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. Above all, Empire Company Limited (TSE:EMP.A) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What is Empire’s debt?
The image below, which you can click on for more details, shows that Empire had C$866.5 million in debt at the end of August 2022, a reduction from 1.23 billion Canadian dollars over one year. On the other hand, it has C$371.5 million in cash, resulting in a net debt of approximately C$495.0 million.
How healthy is Empire’s balance sheet?
The latest balance sheet data shows that Empire had liabilities of C$3.89 billion due within one year, and liabilities of C$7.22 billion falling due thereafter. In compensation for these obligations, it had cash of 371.5 million Canadian dollars as well as receivables valued at 763.7 million Canadian dollars maturing within 12 months. Thus, its liabilities total C$9.98 billion more than the combination of its cash and short-term receivables.
When you consider that this shortfall exceeds the company’s C$9.26 billion market capitalization, you might well be inclined to take a close look at the balance sheet. In the scenario where the company were to quickly clean up its balance sheet, it seems likely that shareholders would suffer significant dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Empire’s low debt to EBITDA ratio of 0.27 suggests only modest debt utilization, the fact that EBIT only covered interest expense by 5.0 times last year makes think. But the interest payments are certainly enough to make us think about the affordability of its debt. We have seen Empire increase its EBIT by 7.7% over the last twelve months. It’s far from amazing, but it’s a good thing when it comes to paying down debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s future earnings, more than anything, that will determine Empire’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecasts.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, Empire has actually produced more free cash flow than EBIT over the past three years. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Empire’s conversion of EBIT to free cash flow was a real benefit in this analysis, as was its net debt to EBITDA. On the other hand, its level of total liabilities makes us a little less comfortable about its indebtedness. When we consider all the factors mentioned above, we feel a bit cautious about Empire’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. Of course, we wouldn’t say no to the extra confidence we’d gain if we knew Empire insiders bought stock: if you’re on the same page, you can find out if insiders are buying by clicking on this link.
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.
Valuation is complex, but we help make it simple.
Find out if Empire is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.