Howard Marks put 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 every investor practice that I know is worried “. 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. We notice that Chesapeake Utilities Corporation (NYSE: CPK) has debt on its balance sheet. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. 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, 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. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is the net debt of Chesapeake Utilities?
The image below, which you can click for more details, shows Chesapeake Utilities owed $ 678.3 million in debt at the end of March 2021, a reduction from $ 710.1 million. over a year. And he doesn’t have a lot of cash, so his net debt is about the same.
How healthy is Chesapeake Utilities’ balance sheet?
The latest balance sheet data shows that Chesapeake Utilities had liabilities of US $ 316.0 million due within one year, and liabilities of US $ 911.6 million due thereafter. In compensation for these obligations, he had cash of US $ 5.58 million as well as receivables valued at US $ 85.7 million within 12 months. It therefore has liabilities totaling US $ 1.14 billion more than its cash and short-term receivables combined.
This deficit is not that bad because Chesapeake Utilities is worth US $ 2.05 billion, and could therefore probably raise enough capital to consolidate its balance sheet, should the need arise. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Chesapeake Utilities has a debt to EBITDA ratio of 3.5 and its EBIT covered interest expense 5.8 times. This suggests that while debt levels are significant, we would stop calling them problematic. We note that Chesapeake Utilities has increased its EBIT by 20% over the past year, which should make it easier to repay debt going forward. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chesapeake Utilities’ ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, Chesapeake Utilities has spent a lot of money. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
Chesapeake Utilities’ struggle to convert EBIT to free cash flow made us guess at the strength of its balance sheet, but the other data points we considered were relatively interesting. In particular, its EBIT growth rate has revived. It should also be noted that Chesapeake Utilities belongs to the gas utilities sector, which is often viewed as quite defensive. Taking the above factors together, we believe that the debt of Chesapeake Utilities presents certain risks to the business. While this debt may increase returns, we believe the company now has sufficient leverage. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 2 warning signs with Chesapeake Utilities, and understanding them should be part of your investment process.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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