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. As with many other companies PriceSmart, Inc. (NASDAQ:PSMT) makes use of debt. But the more important question is: how much risk is that debt creating?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does PriceSmart Carry?
The image below, which you can click on for greater detail, shows that PriceSmart had debt of US$134.5m at the end of November 2021, a reduction from US$180.5m over a year. However, it does have US$217.0m in cash offsetting this, leading to net cash of US$82.5m.
A Look At PriceSmart’s Liabilities
According to the last reported balance sheet, PriceSmart had liabilities of US$594.2m due within 12 months, and liabilities of US$253.0m due beyond 12 months. On the other hand, it had cash of US$217.0m and US$32.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$597.8m.
PriceSmart has a market capitalization of US$2.35b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, PriceSmart boasts net cash, so it’s fair to say it does not have a heavy debt load!
Also good is that PriceSmart grew its EBIT at 18% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine PriceSmart’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. PriceSmart may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, PriceSmart recorded free cash flow of 41% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Summing up
While PriceSmart does have more liabilities than liquid assets, it also has net cash of US$82.5m. And we liked the look of last year’s 18% year-on-year EBIT growth. So we don’t have any problem with PriceSmart’s use of debt.