These 4 Measures Indicate That McCarthy & Stone (LON:MCS) Is Using Debt Extensively
Simply Wall St
David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, McCarthy & Stone plc (LON:MCS) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
As you can see below, McCarthy & Stone had UK£87.8m of debt at February 2019, down from UK£115.1m a year prior. However, because it has a cash reserve of UK£31.8m, its net debt is less, at about UK£56.0m.
LSE:MCS Historical Debt, September 24th 2019
A Look At McCarthy & Stone's Liabilities
We can see from the most recent balance sheet that McCarthy & Stone had liabilities of UK£135.1m falling due within a year, and liabilities of UK£80.1m due beyond that. Offsetting these obligations, it had cash of UK£31.8m as well as receivables valued at UK£10.2m due within 12 months. So it has liabilities totalling UK£173.2m more than its cash and near-term receivables, combined.
This deficit isn't so bad because McCarthy & Stone is worth UK£790.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
McCarthy & Stone has a low net debt to EBITDA ratio of only 0.92. And its EBIT covers its interest expense a whopping 19.3 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for McCarthy & Stone if management cannot prevent a repeat of the 31% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 McCarthy & Stone can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, McCarthy & Stone recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
McCarthy & Stone's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that McCarthy & Stone's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given McCarthy & Stone has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
