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. Importantly, Skyline Champion Corporation (NYSE:SKY) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Skyline Champion’s Net Debt?

As you can see below, Skyline Champion had US$65.1m of debt at April 2021, down from US$111.2m a year prior. However, it does have US$262.6m in cash offsetting this, leading to net cash of US$197.5m.

A Look At Skyline Champion’s Liabilities

The latest balance sheet data shows that Skyline Champion had liabilities of US$263.6m due within a year, and liabilities of US$85.6m falling due after that. Offsetting this, it had US$262.6m in cash and US$57.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$29.2m.

This state of affairs indicates that Skyline Champion’s balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it’s hard to imagine that the US$3.19b company is struggling for cash, we still think it’s worth monitoring its balance sheet. While it does have liabilities worth noting, Skyline Champion also has more cash than debt, so we’re pretty confident it can manage its debt safely.

And we also note warmly that Skyline Champion grew its EBIT by 19% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Skyline Champion can strengthen its balance sheet over time.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Skyline Champion has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last two years, Skyline Champion actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.

Summing up

We could understand if investors are concerned about Skyline Champion’s liabilities, but we can be reassured by the fact it has has net cash of US$197.5m. And it impressed us with free cash flow of US$146m, being 104% of its EBIT. So we don’t think Skyline Champion’s use of debt is risky. There’s no doubt that we learn most about debt from the balance sheet.