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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 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, PRGX Global, Inc. (NASDAQ:PRGX) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is PRGX Global’s Net Debt?
As you can see below, at the end of March 2019, PRGX Global had US$29.7m of debt, up from US$13.6m a year ago. Click the image for more detail. However, it does have US$12.2m in cash offsetting this, leading to net debt of about US$17.5m.
How Strong Is PRGX Global’s Balance Sheet?
We can see from the most recent balance sheet that PRGX Global had liabilities of US$29.6m falling due within a year, and liabilities of US$39.2m due beyond that. On the other hand, it had cash of US$12.2m and US$42.5m worth of receivables due within a year. So its liabilities total US$14.1m more than the combination of its cash and short-term receivables.
Since publicly traded PRGX Global shares are worth a total of US$155.8m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Either way, since PRGX Global does have more debt than cash, it’s worth keeping an eye on its balance sheet.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
PRGX Global has a very low debt to EBITDA ratio of 1.25 so it is strange to see weak interest coverage, with last year’s EBIT being only 2.11 times the interest expense. So one way or the other, it’s clear the debt levels are not trivial. Shareholders should be aware that PRGX Global’s EBIT was down 27% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if PRGX Global can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, PRGX Global saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both PRGX Global’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that PRGX Global’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.