Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that J D Wetherspoon plc (LON:JDW) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is J D Wetherspoon's Net Debt?
As you can see below, J D Wetherspoon had UK£785.5m of debt at January 2019, down from UK£863.1m a year prior. On the flip side, it has UK£37.4m in cash leading to net debt of about UK£748.1m.
How Healthy Is J D Wetherspoon's Balance Sheet?
The latest balance sheet data shows that J D Wetherspoon had liabilities of UK£340.4m due within a year, and liabilities of UK£845.8m falling due after that. On the other hand, it had cash of UK£37.4m and UK£24.3m worth of receivables due within a year. So its liabilities total UK£1.12b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of UK£1.59b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
J D Wetherspoon has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that J D Wetherspoon saw its EBIT drop by 11% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if J D Wetherspoon can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, J D Wetherspoon's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
To be frank both J D Wetherspoon's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Overall, we think it's fair to say that J D Wetherspoon has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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