- Oops!Something went wrong.Please try again later.
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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Kathmandu Holdings Limited (NZSE:KMD) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Kathmandu Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that Kathmandu Holdings had NZ$105.6m of debt in July 2021, down from NZ$241.3m, one year before. However, its balance sheet shows it holds NZ$142.6m in cash, so it actually has NZ$37.0m net cash.
How Healthy Is Kathmandu Holdings' Balance Sheet?
According to the last reported balance sheet, Kathmandu Holdings had liabilities of NZ$236.0m due within 12 months, and liabilities of NZ$410.3m due beyond 12 months. On the other hand, it had cash of NZ$142.6m and NZ$72.4m worth of receivables due within a year. So it has liabilities totalling NZ$431.3m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Kathmandu Holdings has a market capitalization of NZ$1.10b, 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. Despite its noteworthy liabilities, Kathmandu Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that Kathmandu Holdings grew its EBIT by 241% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Kathmandu Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Kathmandu Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Kathmandu Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While Kathmandu Holdings does have more liabilities than liquid assets, it also has net cash of NZ$37.0m. And it impressed us with free cash flow of NZ$148m, being 209% of its EBIT. So we don't think Kathmandu Holdings's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Kathmandu Holdings has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.