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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.’ 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, Citi Trends, Inc. (NASDAQ:CTRN) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Citi Trends

What Is Citi Trends’s Debt?

As you can see below, at the end of August 2020, Citi Trends had US$41.6m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has US$146.7m in cash, leading to a US$105.1m net cash position.

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How Healthy Is Citi Trends’s Balance Sheet?

The latest balance sheet data shows that Citi Trends had liabilities of US$154.1m due within a year, and liabilities of US$183.2m falling due after that. Offsetting this, it had US$146.7m in cash and US$1.06m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$189.6m.

This deficit is considerable relative to its market capitalization of US$306.0m, so it does suggest shareholders should keep an eye on Citi Trends’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Citi Trends also has more cash than debt, so we’re pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Citi Trends if management cannot prevent a repeat of the 38% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Citi Trends will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Citi Trends 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. Happily for any shareholders, Citi Trends actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although Citi Trends’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$105.1m. The cherry on top was that in converted 190% of that EBIT to free cash flow, bringing in US$56m. So we don’t have any problem with Citi Trends’s use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 4 warning signs with Citi Trends (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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. 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.

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