Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 can see that Decibel Cannabis Company Inc. (CVE:DB) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Decibel Cannabis’s Debt?

As you can see below, at the end of June 2020, Decibel Cannabis had CA$37.1m of debt, up from none a year ago. Click the image for more detail. However, because it has a cash reserve of CA$3.88m, its net debt is less, at about CA$33.2m.


A Look At Decibel Cannabis’s Liabilities

The latest balance sheet data shows that Decibel Cannabis had liabilities of CA$12.1m due within a year, and liabilities of CA$37.9m falling due after that. Offsetting these obligations, it had cash of CA$3.88m as well as receivables valued at CA$1.56m due within 12 months. So it has liabilities totalling CA$44.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company’s market capitalization of CA$31.4m, we think shareholders really should watch Decibel Cannabis’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Decibel Cannabis’s earnings that will influence how the balance sheet holds up in the future.

In the last year Decibel Cannabis wasn’t profitable at an EBIT level, but managed to grow its revenue by 671%, to CA$15m. That’s virtually the hole-in-one of revenue growth!

Caveat Emptor

While we can certainly appreciate Decibel Cannabis’s revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Indeed, it lost a very considerable CA$7.2m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through CA$8.1m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start.

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