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. As with many other companies Zenitel NV (EBR:ZENT) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Zenitel Carry?
The image below, which you can click on for greater detail, shows that at December 2019 Zenitel had debt of €2.23m, up from €2.04m in one year. However, it does have €21.3m in cash offsetting this, leading to net cash of €19.1m.
A Look At Zenitel’s Liabilities
We can see from the most recent balance sheet that Zenitel had liabilities of €24.2m falling due within a year, and liabilities of €2.35m due beyond that. Offsetting these obligations, it had cash of €21.3m as well as receivables valued at €14.4m due within 12 months. So it can boast €9.17m more liquid assets than total liabilities.
This excess liquidity suggests that Zenitel is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don’t think it will have any issues with its lenders. Simply put, the fact that Zenitel has more cash than debt is arguably a good indication that it can manage its debt safely.
Also good is that Zenitel grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zenitel’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Zenitel 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. Over the most recent three years, Zenitel recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company’s debt, in this case Zenitel has €19.1m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 17% over the last year. So we don’t think Zenitel’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 1 warning sign for Zenitel that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.