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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies FORTEC Elektronik AG (FRA:FEV) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is FORTEC Elektronik’s Debt?
As you can see below, at the end of March 2019, FORTEC Elektronik had €5.65m of debt, up from €4.77m a year ago. Click the image for more detail. However, it does have €7.93m in cash offsetting this, leading to net cash of €2.28m.
How Strong Is FORTEC Elektronik’s Balance Sheet?
According to the last reported balance sheet, FORTEC Elektronik had liabilities of €11.4m due within 12 months, and liabilities of €6.04m due beyond 12 months. Offsetting these obligations, it had cash of €7.93m as well as receivables valued at €12.0m due within 12 months. So it actually has €2.46m more liquid assets than total liabilities.
This short term liquidity is a sign that FORTEC Elektronik could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that FORTEC Elektronik has more cash than debt is arguably a good indication that it can manage its debt safely.
The good news is that FORTEC Elektronik has increased its EBIT by 3.9% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if FORTEC Elektronik can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. FORTEC Elektronik 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. In the last three years, FORTEC Elektronik’s free cash flow amounted to 48% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that FORTEC Elektronik has net cash of €2.3m, as well as more liquid assets than liabilities. And it also grew its EBIT by 3.9% over the last year. So we are not troubled with FORTEC Elektronik’s debt use. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check FORTEC Elektronik’s dividend history, without delay!
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.
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