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Is Brickworks (ASX:BKW) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Brickworks Limited (ASX:BKW) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

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See our latest analysis for Brickworks

What Is Brickworks's Net Debt?

As you can see below, Brickworks had AU$333.1m of debt, at July 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has AU$74.9m in cash leading to net debt of about AU$258.2m.

ASX:BKW Historical Debt, October 7th 2019
ASX:BKW Historical Debt, October 7th 2019

How Healthy Is Brickworks's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Brickworks had liabilities of AU$261.8m due within 12 months and liabilities of AU$663.8m due beyond that. Offsetting this, it had AU$74.9m in cash and AU$147.1m in receivables that were due within 12 months. So its liabilities total AU$703.7m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Brickworks has a market capitalization of AU$2.61b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Brickworks's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Brickworks's EBIT shot up like bamboo after rain, gaining 42% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Brickworks's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Brickworks actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that Brickworks's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its interest cover. When we consider the range of factors above, it looks like Brickworks is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Brickworks insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.