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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies. StatPro Group plc (LON:SOG) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does StatPro Group Carry?
The image below, which you can click on for greater detail, shows that at December 2018 StatPro Group had debt of UK£27.2m, up from UK£24.5m in one year. However, because it has a cash reserve of UK£2.59m, its net debt is less, at about UK£24.6m.
A Look At StatPro Group’s Liabilities
We can see from the most recent balance sheet that StatPro Group had liabilities of UK£35.2m falling due within a year, and liabilities of UK£25.4m due beyond that. Offsetting this, it had UK£2.59m in cash and UK£13.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£44.9m.
This deficit isn’t so bad because StatPro Group is worth UK£99.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Since StatPro Group does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While StatPro Group’s debt to EBITDA ratio (3.75) suggests that it uses debt fairly modestly, its interest cover is very weak, at 1.82. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that StatPro Group grew its EBIT a smooth 88% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if StatPro Group 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, StatPro Group’s free cash flow amounted to 47% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On our analysis StatPro Group’s EBIT growth rate should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. In particular, interest cover gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about StatPro Group’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. While StatPro Group didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.