The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Carbon Revolution Limited (ASX:CBR) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Carbon Revolution Carry?
The image below, which you can click on for greater detail, shows that Carbon Revolution had debt of AU$16.5m at the end of December 2020, a reduction from AU$18.5m over a year. However, it also had AU$15.4m in cash, and so its net debt is AU$1.09m.
A Look At Carbon Revolution's Liabilities
According to the last reported balance sheet, Carbon Revolution had liabilities of AU$21.5m due within 12 months, and liabilities of AU$22.7m due beyond 12 months. Offsetting this, it had AU$15.4m in cash and AU$4.26m in receivables that were due within 12 months. So it has liabilities totalling AU$24.5m more than its cash and near-term receivables, combined.
Given Carbon Revolution has a market capitalization of AU$345.5m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Carbon Revolution has a very light debt load indeed. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Carbon Revolution's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
In the last year Carbon Revolution wasn't profitable at an EBIT level, but managed to grow its revenue by 23%, to AU$36m. Shareholders probably have their fingers crossed that it can grow its way to profits.
While we can certainly appreciate Carbon Revolution's revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Indeed, it lost a very considerable AU$37m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled AU$36m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Carbon Revolution (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.
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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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.
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