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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that ULS Technology plc (LON:ULS) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 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. 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 think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does ULS Technology Carry?
As you can see below, ULS Technology had UK£4.75m of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have UK£1.85m in cash offsetting this, leading to net debt of about UK£2.90m.
How Strong Is ULS Technology’s Balance Sheet?
We can see from the most recent balance sheet that ULS Technology had liabilities of UK£9.14m falling due within a year, and liabilities of UK£2.78m due beyond that. Offsetting this, it had UK£1.85m in cash and UK£1.64m in receivables that were due within 12 months. So it has liabilities totalling UK£8.43m more than its cash and near-term receivables, combined.
Of course, ULS Technology has a market capitalization of UK£42.8m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
ULS Technology has a low net debt to EBITDA ratio of only 0.52. And its EBIT easily covers its interest expense, being 41.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, ULS Technology saw its EBIT drop by 2.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ULS Technology 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, ULS Technology produced sturdy free cash flow equating to 80% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
ULS Technology’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its EBIT growth rate does undermine this impression a bit. When we consider the range of factors above, it looks like ULS Technology is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Given ULS Technology has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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