David Iben put it well when he said, “Volatility is not a risk we care about. What we care about is preventing permanent loss of capital.’ When we think about how risky a business is, we always like to look at the use of debt, as over-indebtedness can lead to ruin. We can see that Stagecoach Group plc (LON:SGC) does use debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt and other obligations become risky for a company when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. When things go really bad, the lenders can take control of the company. However, a more common (but still expensive) situation is that a company has to dilute shareholders at a cheap share price to get its debt under control. That said, the most common situation is for a company to manage its debt fairly well — and for its own benefit. The first step in considering a company’s debt levels is to consider its cash and debt together.
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How much debt does Stagecoach Group bear?
You can click on the image below for the historical figures, but it shows Stagecoach Group had UK £843.2 million in debt as of May 2021, up from UK £636.9 million, over a year. On the other hand, the UK has £602.3 million in cash, leading to a net debt of around UK £240.9 million.
How strong is Stagecoach Group’s balance sheet?
If we zoom in on the latest balance sheet data, we can see that Stagecoach Group had debts of £779.0 million within 12 months and debts of £835.9 million thereafter. On the other hand, within a year it had cash of £602.3 million and UK £117.3 million in receivables. So his liabilities outweigh the sum of his cash and (current) receivables at UK£895.3m.
The deficit weighs heavily on the £427.5 million British company itself, as if a child is struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. So we definitely think shareholders should keep a close eye on this. After all, Stagecoach Group would likely need a major recapitalization if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to income. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how often earnings before interest and taxes (EBIT) will cover interest costs (or interest coverage for short). In this way, we take into account both the absolute amount of the debt and the interest rates paid on it.
While Stagecoach Group has a fairly reasonable net debt to EBITDA of 1.9, the interest coverage seems weak at 1.9. In large part, it has so many depreciations and write-downs. These charges can be non-cash, so they can be excluded when it comes to paying off debt. But the accounting costs are there for a reason — some assets seem to lose value. Either way, there is no doubt that the stock uses some meaningful leverage. Also pertinently, Stagecoach Group has grown its EBIT by a very respectable 27% over the past year, making it more able to service debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the future profitability of the company will decide whether Stagecoach Group can strengthen its balance sheet over time. So if you want to see what the pros think, you might find this free analyst earnings forecast report be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t do it. So we always look at how much of that EBIT is translated into free cash flow. Over the last three years, Stagecoach Group produced solid free cash flow equal to 67% of its EBIT, roughly what we would expect. This cold hard money means it can reduce its debt whenever it wants to.
While Stagecoach Group’s interest coverage makes us cautious about it, its track record of keeping abreast of its aggregate liabilities is no better. But at least the EBIT growth rate is a shiny silver lining to those clouds. Considering all the factors discussed, it seems to us that Stagecoach Group is taking some risks with the use of debt. While that debt could boost returns, we think the company has enough leverage now. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks reside within the balance sheet – far from it. For example, Stagecoach Group has: 3 warning signs (and 1 that is significant) we think you should know.
If you are the type of investor who prefers to buy stocks without debt, don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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This article from Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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