Preparing for Earnings Season – Monitoring The Trend of Increased Leverage

In the last twelve months, we have noticed some very positive trends in US MSO Cannabis companies. For example, Free Cash Flow and EBITDA margins have been increasing significantly in the right direction. Many MSOs with excess Free Cash Flow can pay down debt. However, we have noticed a trend of US MSO cannabis companies increasing their debt and becoming more leveraged. This article will discuss how we measure this, which US MSOs have the most leverage, and which companies have been increasing their leverage the most. 

How do we measure company leverage?

I like to use Total liabilities rather than Total Assets. This is similar to a loan to value a home. If you have a home worth $1M and a $500,000 mortgage, you have a 50% Total liability to Total asset ratio. The use of debt is not necessarily bad or good. If they work well, then management’s decision to use leverage is good, but it does add risk, especially when there are challenges. If a company has lower leverage, we are not saying it is better; we are just saying the balance sheet is lower risk. 

Why is the Total Liabilities to Total Assets Ratio Important?

  1. Financial Leverage: It indicates the degree to which a company is using debt to finance its assets. Higher ratios suggest more leverage and potentially higher financial risk.
  2. Risk Assessment: It helps in assessing the financial stability and risk profile of a company. Companies with lower ratios are generally considered less risky.
  3. Comparability: It allows for straightforward comparisons between companies in the same industry by focusing on their leverage and financial health.
  4. Creditworthiness: It provides an insight into the company’s ability to meet its obligations. A lower ratio indicates better creditworthiness and financial stability.

Let’s examine and rank the US MSOs based on their ratio for the last quarter before we look at the trends over the last year. 

When looking at this data, I remind readers that it does not necessarily reflect positively or negatively on the companies. However, it guides investors on which MSO to pick based on their view of leverage. Some investors may prefer higher risk and higher return opportunities. It does highlight, though, that the companies with a lower ratio are lower-risk companies regarding leverage. The key, is for investors to know what they are investing in.

Earlier in the article, I shared that companies have been increasing their leverage in the last twelve months overall. The next chart I share is how much each companies has been increasing or decreasing their leverage. This shows a trend to see if companies are increasing their risk/reward profile or are decreasing their risk/reward profile. 

We can see in the above chart that an increase of 7% in the use of leverage by cannabis MSOs this year has been significant. I contemplate why, and it seems that additional debt is available to cannabis companies as they are maturing, and management has favored using this. As the companies mature, I speculate that these ratios will start to drop as excess cash flows will be used to pay down debt. 

What am I watching during the earning season in August?

I will watch the overall trend for companies, but I will also watch each company to see in what direction it is trending and by how much. I will share this data as it becomes available after the company’s earnings reports. Some companies do not share this information in their press releases and it takes us a couple of days to get our systems updated at Capital IQ / S&P. 

If you enjoyed this article, check our other blogs to help everyone prepare for earrings on tops like:

  1. Selling General and Administrative Margin
  2. Gross Profit Margin
  3. EBITDA Margin

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