October 7, 2022

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. As with many other companies Coventry Group Ltd (ASX:CYG) makes use of debt. But should shareholders be worried about its use of debt?
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.
View our latest analysis for Coventry Group
You can click the graphic below for the historical numbers, but it shows that as of June 2022 Coventry Group had AU$48.4m of debt, an increase on AU$24.5m, over one year. On the flip side, it has AU$15.3m in cash leading to net debt of about AU$33.1m.
We can see from the most recent balance sheet that Coventry Group had liabilities of AU$116.7m falling due within a year, and liabilities of AU$48.6m due beyond that. On the other hand, it had cash of AU$15.3m and AU$50.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$99.2m.
This is a mountain of leverage relative to its market capitalization of AU$123.0m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
While Coventry Group's debt to EBITDA ratio (2.6) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Also relevant is that Coventry Group has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down 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 Coventry Group's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Coventry Group generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Both Coventry Group's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its interest cover had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Coventry Group is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Coventry Group you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Find out whether Coventry Group is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
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Coventry Group Ltd primarily distributes industrial products in Australia and New Zealand.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Reasonable growth potential with adequate balance sheet.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
Find out more about our editorial guidelines and team.
Coventry Group Ltd primarily distributes industrial products in Australia and New Zealand.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Reasonable growth potential with adequate balance sheet.
Simply Wall Street Pty Ltd (ACN 600 056 611), is a Corporate Authorised Representative (Authorised Representative Number: 467183) of Sanlam Private Wealth Pty Ltd (AFSL No. 337927). Any advice contained in this website is general advice only and has been prepared without considering your objectives, financial situation or needs. You should not rely on any advice and/or information contained in this website and before making any investment decision we recommend that you consider whether it is appropriate for your situation and seek appropriate financial, taxation and legal advice. Please read our Financial Services Guide before deciding whether to obtain financial services from us.

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