Are you poorer than you think?

Under International Financial Reporting Standard (IFRS) 16, many Canadian companies must now add lease liabilities to their debt. This can make their balance sheets look weak and greatly raise their net debt-to-cash-flow ratios.

Most Canadian companies are now doing their accounting using International Financial Reporting Standards, or IFRS.

Engineering and construction stock Stuart Olson saw its reported debt greatly increased under IFRS 16.

IFRS 16 requires lessees to recognize assets and liabilities for all leases with a term of more than 12 months. This can raise a company’s reported debt. That, in turn, can raise the company’s net debt-to-cash-flow ratio to levels that look dangerously high.

Stuart Olson now looks at lot worse

Consider, for instance, Calgary-based Stuart Olson Inc. (TSX: SOX) which we regularly review. When we published our May 17 issue, its net debt-to-cash-flow ratio was 4.5 times. That’s above our standard comfort zone of two times or less. But it was not outrageously high. This time, however, Stuart Olson’s net debt-to-cash-flow ratio is a much higher 11.4 times.

Stuart Olson’s liabilities now include the current portion of lease liabilities of $9.5 million. It also includes long-term liabilities of $45 million. These were zero in the company’s annual report.

Stuart Olson’s cash flow is also down

Stuart Olson holds cash of $17.02 million. It also has prepaid expenses of $4.46 million. Subtract this from total debt and lease liabilities of $187.848 million and the company’s net debt is $166.863 million.

There is another reason why Stuart Olson’s net debt-to-cash-flow ratio deteriorated. One is that its cash fell in the first half of 2019. In the first half, the company generated cash flow of only $3.544 million. This is down substantially from the $11.042 million that it generated in last year’s first half. In the latest four quarters, Stuart Olson’s cash flow totaled $14.672 million.

Divide the net debt of $166.863 million by the cash flow of $14.672 million and you get a net debt-to-cash-flow of 11.4 times.

Profits should jump to 28 cents a share

We expect Stuart Olson’s net debt-to-cash-flow ratio to improve. That’s because its profit is expected to jump from two cents a share this year to 28 cents a share next year. Profits, of course, are an important determinant of cash flow. All else being equal, higher cash flow will cut its net debt-to-cash-flow ratio.

Stuart Olson’s expected earnings of 28 cents a share next year will exceed its dividend of 24 cents a share. If the company maintains its dividend, income-seeking investors would be apt to buy it.

The thing is, between now and next year, a lot can change. As a result, we’ve downgraded Stuart Olson to a hold. But only if you can accept holding a stock we rate ‘Higher Risk’.

This is an edited version of an article that was originally published for subscribers in the October 4, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.

The Investment Reporter, MPL Communications Inc.
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