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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Cascades Inc. (TSE:CAS) does use debt in its business. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Cascades Carry?

As you can see below, Cascades had CA$1.86b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CA$384.0m in cash leading to net debt of about CA$1.48b.

How Strong Is Cascades’ Balance Sheet?

The latest balance sheet data shows that Cascades had liabilities of CA$1.03b due within a year, and liabilities of CA$2.42b falling due after that. On the other hand, it had cash of CA$384.0m and CA$682.0m worth of receivables due within a year. So its liabilities total CA$2.39b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CA$1.45b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. At the end of the day, Cascades would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Cascades has net debt worth 2.4 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. 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 Cascades’s EBIT shot up like bamboo after rain, gaining 42% in the last twelve months. That’ll make it easier to manage its debt. 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 Cascades’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Cascades recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Cascades’s ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Cascades’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. There’s no doubt that we learn most about debt from the balance sheet.