Collins Foods (ASX: CKF) Seems to Use Debt Quite Wisely
Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Above all, Collins Foods Limited (ASX: CKF) is in debt. But the most important question is: what risk does this debt create?
When is debt dangerous?
Debts 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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest review for Collins Foods
What is the debt of Collins Foods?
As you can see below, Collins Foods was in debt of A $ 287.9 million in October 2021, up from A $ 317.8 million the year before. However, it has A $ 90.0 million in cash offsetting this, leading to net debt of around A $ 197.8 million.
How strong is Collins Foods’ balance sheet?
According to the latest published balance sheet, Collins Foods had a liability of A $ 140.8 million due within 12 months and a liability of A $ 685.9 million due beyond 12 months. In return, he had A $ 90.0 million in cash and A $ 3.43 million in receivables due within 12 months. As a result, it has liabilities totaling AU $ 733.2 million more than its cash and short-term receivables combined.
This deficit is not that big of a deal as Collins Foods is worth A $ 1.49 billion, and could therefore probably raise enough capital to consolidate its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
We measure a company’s indebtedness relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Collins Foods’ low debt-to-EBITDA ratio of 1.4 suggests only a modest use of debt, the fact that EBIT only covered interest expense 3.3 times last year makes us reflect. We therefore recommend that you keep a close eye on the impact of financing costs on the business. Collins Foods increased its EBIT by 7.0% over the past year. It’s far from incredible, but it’s a good thing when it comes to paying down debt. When analyzing debt levels, the balance sheet is the obvious place to start. But it is future profits, more than anything, that will determine Collins Foods’ ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with accounting profits. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, Collins Foods has recorded free cash flow totaling 95% of its EBIT, which is higher than what we normally expected. This puts him in a very strong position to pay off the debt.
Our point of view
Based on our analysis, converting Collins Foods’ EBIT to free cash flow should indicate that it will not have too many problems with its debt. However, our other observations were not so encouraging. For example, his interest coverage makes us a little nervous about his debt. Given this range of data points, we believe Collins Foods is well positioned to manage its debt levels. That said, the load is heavy enough that we recommend that any shareholder watch it closely. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example – Collins Foods has 1 warning sign we think you should be aware.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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