Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Escalade, Incorporated (NASDAQ:ESCA) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company’s use of debt, we first look at cash and debt together.

What Is Escalade’s Debt?

As you can see below, at the end of March 2021, Escalade had US$46.9m of debt, up from none a year ago. Click the image for more detail. However, it does have US$5.88m in cash offsetting this, leading to net debt of about US$41.0m.

A Look At Escalade’s Liabilities

Zooming in on the latest balance sheet data, we can see that Escalade had liabilities of US$37.7m due within 12 months and liabilities of US$52.4m due beyond that. Offsetting this, it had US$5.88m in cash and US$54.5m in receivables that were due within 12 months. So it has liabilities totalling US$29.7m more than its cash and near-term receivables, combined.

Of course, Escalade has a market capitalization of US$354.1m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Escalade’s net debt is only 0.98 times its EBITDA. And its EBIT covers its interest expense a whopping 85.8 times over. So we’re pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Escalade grew its EBIT by 235% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Escalade can strengthen its balance sheet over time.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Escalade actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Escalade’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Escalade is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.