Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu doesn’t care when he says, âThe biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital â. So it might be obvious that you need to factor in debt, when you think about how risky a given stock is because too much debt can sink a business. Like many other companies CTI Logistics Limited (ASX: CLX) uses debt. But the most important question is: what is the risk that this debt creates?
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap stock price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business is using is to look at its cash flow and debt together.
See our latest analysis for CTI Logistics
How much debt is CTI Logistics?
As you can see below, CTI Logistics was in debt of A $ 35.0 million in December 2020, up from A $ 42.3 million the year before. However, he also had A $ 6.33 million in cash, so his net debt is A $ 28.7 million.
How healthy is CTI Logistics’ balance sheet?
We can see from the most recent balance sheet that CTI Logistics had liabilities of A $ 42.1 million due within one year and liabilities of A $ 81 million beyond. In return for these obligations, he had cash of A $ 6.33 million as well as receivables valued at A $ 30.8 million due within 12 months. As a result, its liabilities total AU $ 85.9 million more than the combination of its cash and short-term receivables.
If you consider that this shortfall exceeds the company’s A $ 63.9 million market cap, you might be inclined to take a close look at the balance sheet. In theory, an extremely large dilution would be necessary if the company were forced to repay its debts by raising capital at the current share price.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).
CTI Logistics has net debt of 2.0 times EBITDA, which is not too much, but its interest coverage seems a bit weak, with EBIT just 2.6 times interest expense. While these numbers do not alarm us, it should be noted that the cost of the company’s debt does have a real impact. Notably, CTI Logistics’ EBIT started higher than Elon Musk, gaining 155% compared to last year. When analyzing debt levels, the balance sheet is the obvious place to start. But it is the profits of CTI Logistics that will influence the balance sheet in the future. So when you consider debt, it’s really worth looking at the profit trend. Click here for an interactive snapshot.
But our last consideration is also important, because a business cannot pay its debt with profits on paper; he needs cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, CTI Logistics has actually generated more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
Our point of view
CTI Logistics’ ability to convert EBIT into free cash flow and its EBIT growth rate reassured us about its ability to manage its debt. On the other hand, our confidence was undermined by his apparent struggle to manage all of his liabilities. When we consider all of the factors mentioned above, we feel a little cautious about the use of debt by CTI Logistics. While we believe that debt can improve return on equity, we suggest shareholders watch their debt level closely, lest they increase. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. Know that CTI Logistics shows 4 warning signs in our investment analysis , and 2 of these make us uncomfortable …
Of course, if you are 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 net growth stocks, today.
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